Types of debt : Good debt vs Bad debt

Is there such a thing as good debt ?. Previously I would have answered a resounding NO to this question as I have always avoided debt like the plague.

However, through experience and knowledge over time I have taken on debt in various forms and now feel I can define two types of debt : Good debt and Bad debt.

Good debt

Generally good debt should be strategic and part of a long term sensible plan. It should be clear, manageable, cheap as possible (interest rates), provide opportunities and be affordable to repay.

In a nutshell good debt should be an investment.

Let's look at some examples of good debt.

Investing in your business

Businesses are a great way to generate money but you don't get something for nothing in this life. Therefore, depending on the type of business you are going to start you may need some initial expenditure. This could be for equipment, premises or staff etc and will get your money making machine up and running. There is a saying that you have to 'spend money to make money' and a business is a prime example.

Any kind of debt should always be treated with caution as it can be a fine line between success and failure. If you are going to take out a business loan make sure you have a solid business plan and all of the skill, drive and determination to make it turn a profit. If you get this right you can repay the loan and everything else you get to keep.

Student Loans

Student loans to pay for University can be very beneficial for your future. Graduates generally get paid more than non-graduates so a university degree is definitely worth pursuing. Many would agree that 5 years to repay a loan is a small price to pay for a 45 year high earning career.

Much like the business loan you have to be careful. Only borrow what you need, don't waste money and make sure you work hard and get a good qualification. If you can save some of your student loan to act as a deposit for a property even better !.

Mortgages

Rental prices are increasing all the time and is effectively 'dead money'. The beauty of a mortgage is that not only does it give you a roof over your head but once the loan is repaid it also gives you a huge financial asset. Property appreciates over time so your money is making more money which is great especially coupled with the fact that your mortgage payments are still likely to be cheaper than paying rent.

Home improvements

Now this item won't feature on most lists under good debt because it is a broad category that can mean many things. In my definition borrowing money for home improvements means two things : Finding a zero (or close to zero) per cent credit card or loan and making improvements that are long term.

Examples of this are as follows :

• Structural work which are essential for the property to be safe e.g. rewiring and plumbing
• Long term items which make the house livable and comfortable such as carpets, sofa, heat efficient doors, new bathroom and kitchen. As a rule ask yourself 'will I still have this item in 5 years?'.

Not only will this improve your life short and long term (a key characteristic of good debt) but it will add value to your property which is money in your pocket.

Like with all the good debt just make sure you can afford to repay it in a time frame that works for you.

Bad debt

If good debt is strategic and part of a long term sensible plan then bad debt is the opposite. With good debt we invest in the short term and in appreciating assets whereas bad debt places us in deficit with little or no future return.

Here are some examples :

Car loans

Other articles I have seen say that car loans can be good debt if you can afford it and is a statement I completely disagree with. Cars are DEPRECIATING assets and will always result in a loss 5 years down the line. I personally have always saved and purchased my cars cash which hasn't given me the best cars in the world but when my circumstances have changed I never had to worry. Knowing that no-one had a claim over your means of getting to work or running essentials errands is very reassuring. Car loans act as a compounded loss because not only is the car's value depreciating you also have to pay the loan amount back with interest. It is lose-lose.

Clothes

Unfortunately I have witnessed many people end up with financial problems due to spending excessively on clothes and fashion accessories. Not only do these items wear out in short period of time but some remain in good shape but simply fall out of the latest fashion trend and therefore are no longer wearable. The sad reality is some people are still losing a portion of their monthly income for outfits they wore briefly 4 years ago.

Home fashion items

Home improvements are good but home fashion items are bad if your paying for them with credit or loans. Ornaments, fashionable art and soft furnishings etc look good now but they will be out next summer when you want a fresh look. You may throw these out but the debt remains.

Borrowing money to pay regular bills

I implore anybody who is using money to pay living expenses (bills) or other credit commitments to contact debt management organisations for advice. These are free and have been setup to help people that are caught in this difficult and distressing situation. For those that are contemplating short term or 'pay day' loans please also utilise these organisations as these short term schemes are designed to dig you further into long term debt while giving you short term relief.

Holidays

These are the worst form of bad debt probably owed to the fact they have a specific time limit. For that 1 week holiday you could be paying for it for 3 years. If you want a holiday each year and use debt each time to pay for it, you are subscribing to a life of money worries.

Hopefully this article has shown that debt can be good and bad. If you are careful you can make debt work for you in a positive way and enhance your life or alternatively it can work against you.  So understand the risks, make sure it's affordable and always read the small print.

If you found this article helpful or would like to share your thoughts on the types of debt mentioned, please leave your comments below.

FTSE 100 UK stock Return On Capital Employed (ROCE) list

After watching a video  (3 tips for finding good companies) from Terry Smith
explaining why his fund Fundsmith Equity is so successful, I decided to follow his advice and take a look at some FTSE 100 stocks to see how they measured up.

In the video his first tip referred to Return On Capital Employed (ROCE). I had heard of this calculation before but had never looked into and applied it to prospective stocks. The first step was to learn what ROCE is and how to calculate it based on the financial reports from a company. I completed this step and then looked at 22 different FTSE 100 companies and calculated their ROCE percentage.

The results are as follows :

Company	Net Profit Before Tax 2014	Net assets 2014	ROCE %
Admiral	350.7	580.9	60
Astrazenica	1246	19646	6
Aviva	2663	12276	22
BAE	882	1877	47
Barclays	2256	65958	3
BATS	4848	26167	19
BP	4950	112642	4
Glaxo	2968	4936	60
HSBC	18680	199978	9
Imperial Tobacco	1525	5696	27
Legal & Gen	1413	6303	22
Lloyds	1762	49903	4
Nat Grid	2628	11974	22
RBS	2643	60192	4
RDSB	28314	172786	16
Severn Trent	318.9	823.3	39
SSE	592.5	5119.5	12
Standard Life	422	4950	9
Taylor Wimpey	468.8	2535.3	18
Unilever	7646	14263	54
United Utilities	543.3	2215.9	25
Vodafone	-5270	71781	-7

Having reviewed the list it becomes instantly apparent why he uses this calculation as an initial filter. Applying this alone would save you from investing in the likes of Barclays, BP, RBS and HSBC which have all yielded terrible results for investors. However, it would encourage taking a closer look at Unilever, Severn Trent, Glaxo and BAE which are proven to be fundamentally sound.

If you like this post or would just like to contribute some thoughts, please leave a comment.

3 tips for finding good companies from Fundsmith Equity Fund Manager Terry Smith

I discovered Terry Smith some time ago and invested in his Fundsmith Equity Fund which has yielded some impressive returns over the years. He like Warren Buffett is obviously a master at what he does and this morning I found a video where he tells you how he does it.



In the video Terry refers to three basic principles when trying to select a 'good' company :

1. Don't buy a company with a low Return On Capital Employed (ROCE) percentage which he states should be above 15% and definitely no lower than 10%.
2. Work out what percentage of the company's profits arrive in cash and if the answer isn't 90% or more - don't invest.
3. Does the company make it's money from a  large number of everyday repeat predictable transactions i.e. you don't want to select a company that relies on one off things that may or may not happen such as winning contracts.

I have purchased many individual stocks and tried to use some sound fundamentals but I have never implemented a filter like this one so I will be trying it out and reporting back in future posts.

If you like this post or would just like to contribute some thoughts, please leave a comment.

Basic dividend reinvestment goals and planning for passive income

Several years ago I knew that dividends were a good source of passive income and that passive income was a great entity to pursue. However, I didn't know how to pick good dividend stocks or have any plan/reinvestment strategy for my dividends once I received them.

Picking the right dividend stocks I will cover in a different post but one of the most important factors for dividend investing success is the system that you place around your dividends to grow and compound your returns.

This still sounds abit too complicated for my liking so let's start with a dividend investing goal.

"To make your dividend portfolio SELF FUNDING" 

So what do we mean by this : Basically we want to use our earned money e.g. salary to purchase our dividend paying stocks and then use the dividends received to buy more stocks. The beauty of this scenario is that we start off buying all of our stocks and then the stocks start buying themselves !

There are two approaches you can take with this strategy one is 'capped' and the other is 'uncapped'.

CAPPED EXAMPLE

In this example the cap refers to the maximum amount we will invest in our dividend portfolio each month. To keep the numbers simple I have selected £100, your amount will depend on your circumstances and attitude towards risk. Lets imagine your timing is good and you catch a record date for a stock that has a payment date the month after.

August

Dividend received : zero as you have not previously purchased any stock.
Salary : £100 from your salary  goes into buying your first dividend stock.
Amount invested :£100

September 

Dividend received : £5 received from the dividend stock you purchased the previous month which can now be reinvested.
Salary : £95 from your salary  goes into buying more dividend stocks
Amount invested :£100

October 

Dividend received : £7 received from the dividend stock you purchased the previous month which can now be reinvested.
Salary : £93 from your salary  goes into buying more dividend stock.
Amount invested :£100

In summary you cap your investment amount at a figure in this case £100 and then use your dividends received to reduce the amount you have to put in from your salary each month. This is great because you still invest £100 and you also get to save your own salary for use elsewhere in your life !.

UNCAPPED EXAMPLE

So this approach is much simpler you still decide on an amount each month that you want to invest but you never reduce that amount even when you receive dividends. To use the examples above the monthly invested amounts would be.

August : £100
September :  £105
October : £107

As you can see you will increase your portfolio worth faster but it all comes down to your personal choice.

I stated earlier that the goal is for the portfolio to become self funding and this is what I am working towards. For the above portfolio to become self funding you would need to be receiving £100 a month in dividends. If you are using the capped method you can at this point cease your salary payments into your portfolio and just reinvest the dividends received. Thus the portfolio is funding itself.

This has been a very successful strategy for me and if you are going to try this approach, are already doing something similar or have your own strategy it would be great to hear from you in the comments section.