If your family are anything like mine then as a kid you learnt that credit is bad. Something to be wary of. Used as a last resort.
Oft repeated wise words about saving for something first before buying it. Experts in delaying gratification.
All valuable lessons – absolutely. Clearly advice and practice that came in very useful on my journey to financial independence.
But it can be very easy in the personal finance/financial independence world to want to keep things simple and clear cut. This is good, that is bad, kind of writing.
But very few things in life are always so black and white. There’s always exceptions, a few grey areas.
And so in support of the Plutus Foundation monthly challenge for January, I thought I’d take a bit of a deeper dive on the topic.
Going beyond the obvious ‘fix your credit score’, ‘this credit card is the best’ type stuff.
Instead looking at when credit is bad – and when it is good. And when it is something in-between…
A Credit Example - Education
Back when I was a student, it was much more of a no-brainer question about whether going to university (college for those in the US) was worth it or not.
I didn’t get to go in the days of full grants but I didn’t have to pay for any of the further education. Simply raise enough funds to live on through working and maxing out the available student loans.
I ended up with a debt of about £3500 at the end of the three years. Even using this handy converter tool to adjust for inflation into real terms that’s about £7k in today’s money.
Which looks pretty good stacked against todays average student debt in England of £45k. The rest of the UK is a lot lower with lower caps or free tuition (Scotland) still – as this helpful graph from Statista shows;
That said, it’s interesting that in that same link above the UK government only expect about 25% of all student loans to be paid in full. Suggesting that the average debt paid is actually lower.
Regardless, it’s still a hefty financial commitment these days. So how do you know if it’s a good use of credit or not?
From a purely financial perspective, it’s all going to come down to how much extra you can expect to earn over your working lifetime.
Which raises an especially interesting perspective for people also interested in FIRE – with a (hopefully!) shorter than average working period. Will using credit for education be financially worth it?
For example, if you plan on retiring early like me in your forties then you have between 20 – 30 years worth of ‘work’ to get value out of a basic degree.
According to this wrap up of Dept of Education stats, the median life time salary of a graduate is £34k compared to £25k for non-grads. So an average 25 years of working for a FIRE’r would net you an additional 25 x £9k, i.e. about £225k.
Stack that up against that average cost of £45k and you get an average APR of ~6.5%. Not too bad but worth remembering that ignores increased taxes, national insurance and the like.
It also ignores the fact that medium or average numbers tend to be a bit useless when judging this decision for yourself.
The range of average graduate salaries is huge. Massive. Swinging those return numbers respectively from a negative 2% through to ~9%.
Now personally I’m a big believer in education for reasons way beyond what you actually learn. But sticking with the financial logic for now.
This example illustrates what makes the whole is credit good or bad debate interesting to me. It’s neither one or the other – it’s simply a tool.
And like any tool – you can use it well – or you can use it to really do some damage..
So – how best to tell the difference?
As ever, it depends is the unsatisfactory but expected answer…
Credit - From A Financial Perspective
So where do you start when figuring out if credit is the right tool for the job?
Financially, it seems pretty simple to me. A few fundamental rules of thumb that I tend to use as to what makes financial sense – and what doesn’t.
First up – what do I want the credit for? Is it something value-adding? Some kind of investment? Or is it purely a luxury? Do I need it for something on my ‘Must’ list of expenditures – or is it one of those fun but discretionary things?
Why does it matter? Well, if you’re investing in something that generates value in some way, then you can figure out the actual (hopeful) financial return.
E.g. say you want to buy a car. That could be thought of as entirely discretionary if you live anywhere with vaguely reasonable public transport. But would it stack up financially if it actually saves you money over the transport fees?
My old commute to London used to cost me north of £7k a year – ouch. If I’d been at all awake enough to drive both ways it would probably have worked out cheaper. But the chance of grabbing some bonus sleeping on that hideous 2+hour commute each way – priceless to me!
But if I had gone for the car option – there would have been a price point where the numbers worked – or didn’t. A brand new off-the forecourt deal unlikely to work out – our second hand small and ultra efficient one – yup.
After 20 odd years in the industry, I’m pretty programmed to run mini business case scenario thinking like this. But it doesn’t have to be that complicated.
Just figure out what you expect to get back at the end. And how that compares to the amount you’re investing.
If it generates a positive return that you’re happy with – great. You’re ready for ‘rule’ number two…
What Happens If...
Always know your escape plan, as I like to call it…what happens if you can’t afford the payments anymore?
You lose your job, get sick. You name it, there’s a whole stinking pile of ‘life happens’ type things that we all have to deal with from time to time.
So if the worst happens – what will you do? Is there a tangible asset you can sell easily? Or will you be stuck between the proverbial rock and hard place?
In my car example above I’d have had a relatively easy asset to sell – all be it perhaps at a loss to the original price. In the education example, the loans aren’t even due until you actually earn any money.
But not all credit examples have such obvious outs. So try and make sure you know what your exit plan is – before you go ahead!
Now all of this is all well and good if your plan makes good financial sense – but there’s also plenty of times when it doesn’t. After all, 51% of our annual budget was on discretionary spending in our first full retirement year. Hey – the whole point of early retirement was to live more after all!
So does that mean I didn’t use credit for any of that spending? Of course not – credit cards are a great tool to have at your disposal. When you use them well that is.
And by that I mean the obvious stuff. Pay them off in full each month. Take advantage of the additional financial protection they offer. I’m also a big fan of using them for travel hacking but that’s another subject entirely..
All sounds simple and obvious – right? And that’s because it is – from a purely logical, financial perspective. But that’s not the reality of either the world or people…
The Emotional Side Of Credit
Since when is anything just a financial decision?
If everyone used credit cards like I do now, they wouldn’t exist anymore. They don’t make enough money off my kind of usage.
In fact, a whole lot of the personal finance world wouldn’t exist if everything was as logical or clear cut as the maths made out.
It’s a sad but true fact that the more you need credit – the harder it is to get..
That’s why there are reams of helpful blogs about how to improve your credit score. Use zero interest offers and transfer balances. And so on.
Because whether you admit it or not – most of our financial decisions have an emotional element to them. And the world of credit knows it.
The barrage of ‘buy now pay later’ adverts are a great example. Tempting people to indulge with low ‘oh so affordable’ payments.
Debt looks so much more manageable on a monthly basis than an annual one!
The move to subscription based services is another classic example. No end in sight and on the day you stop paying, it’s all gone. No tangible asset left.
Again – it doesn’t make these types of using credit ‘bad’ or ‘good’ – it’s just how you use them that makes the difference.
Eyes open and all that. Always remember the purpose of these companies is to make money. You are their livelihood.
If you understand when and how you will help them with their money making aims, you can choose if it’s a deal that also works for you or not.
It brings the decision back into the financial, logical side. Avoiding those emotional tugs and well marketed nudges.
But does that mean there’s never a good case for ‘bad’ credit? Perhaps a little controversially, I don’t think so.
Can Bad Credit Ever Be Good?
It can be very easy in the personal finance/financial independence world to want to keep things simple. Easier to sell if that’s your game.
But I’ve always found grey areas the most interesting corners of the world. Very few things are actually 100% right or wrong – it all comes down to perspective.
For example – having gone through all the above you would (hopefully) conclude that taking out a large personal loan at an extortionate interest rate to finance a luxury trip away would quite easily tick the boxes of bad credit usage.
But what about if that same trip is for a terminally ill loved one? Looking to create some final happy memories, bringing what pleasure you can. Is it still a bad use of credit?
Even if you know it leaves you a debt you have no possibility of managing?
Or to take a more positive example. What about starting up your own business? It’s a big financial gamble however much thought and planning you put into it. The upside can be huge though – so is it worth taking on credit you might not be able to afford?
In these days where it’s no longer such a scandal to default on debt, I don’t think all credit situations are as black and white as people would like to believe they are.
Loans are regularly written off. People and companies go bankrupt. It’s far more widely accepted these days and far less of a stumbling block to starting over than it used to be.
At my old company – and pretty much everywhere else dealing with the financial trading world – it was standard practice to expect a certain percentage of credit losses each year. Modelling the entire collection as a portfolio with the expectation of some failures.
Indeed we often had conversations about not taking enough credit risk as we weren’t getting the expected failure rate!
However, that’s an entirely different all be it interesting subject in it’s own right.
What I’m getting at is that it’s not always black and white. There can be legitimate reasons for using credit for bad reasons. Just not bad financial reasons.
And that’s why I think what matters to me is understanding why you are doing it. Be it for financial or emotional reasons – or most likely a bit of both.
And then consciously choosing to use credit in the best way possible.
That’s why credit is simply another financial tool – and there’s a lot you can learn to use it to your advantage. Credit isn’t bad – it can be a great help in many different ways.
But if you can master that emotional and logical balance in making these decisions – that’s when I think you really start to use credit well.
Thoughts?
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The nudge theory, in respect of auto-enrolling pensions, has been a good thing but as with many ideas founded on good intentions, someone always manages to find ways of using it for nefarious intentions!
I have a mixed relationship with credit – I obviously didn’t listen to my parents and got myself in a pickle with a lot of consumer debt which took me a while to clear up. It’s probably one reason why I didn’t use leverage to pick up another BTL when I had the opportunity, because I was uncomfortable with taking on more debt., even though it made sense (at the time). Perhaps I’ve missed out, perhaps not but I can sleep at night in any case!
Ha, ok, fair point on the pensions, you can have that one 😉
You’ve done so well to get out of your debt hole – I sometimes think we just have to go through the experience to learn these kind of lessons ourselves, right. There’s also an awful lot of other good/well-meaning advice I’ve ignored from my parents too!
I can see why it would have left you wary of another BTL, they aren’t always as easy or straight forwards as they seem on paper – and sleeping well at night is never to be under-rated!
It seems that we had similar parenting as I was frequently told “if it’s worth having, then it’s worth saving up for”. As an accountant, I know that debt can be a useful tool, but I do think that my parent’s advice has done me well in terms of my personal life. I think the only things I’ve ever had debt for have been home and vehicles.
What annoys me these days is the marketing around using debt to buy things that are above and beyond what is needed, e.g. buying a luxury vehicle instead of a mid level vehicle, buying new furniture on credit even though your existing furniture is fine. Of course, everyone is free to make their own choice, but I suspect that there are too many consumers who are financially less literate and fall into financial difficulties after being seduced by the “you can afford this” when the reality is that they probably can’t.
Hey David. Ha, not too surprised at the parenting similarities and it’s defn helpful. Exactly – that’s the point I was getting after with understanding the emotional side of using credit – as that’s usually where it ends up going ‘wrong’. I tend to think the whole ‘marketing budget’ definition is “money thrown at convincing people to spend cash on something they’d be fine without”…and don’t get me started on nudge theory….drives me insane!