Good Debt vs Bad Debt vs Ugly Debt

Britain becomes a nation of debt slaves as regulation and inflation deter saving

Britain becomes a nation of debt slaves as regulation and inflation deter saving

By Ian Cowie Your Money Last updated: February 27th, 2012

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Britain's households are drowning in debt

Now that interest on debts absorbs nearly a quarter of British households’ net income, according to the Consumer Credit Counselling Service (CCCS), many families are discovering how cruel a taskmaster compound interest can be.

If you think conventional savings products – like pensions and managed funds – provide poor value, then just wait till you see how bad the ‘returns’ on borrowing are. While instant gratification has come to be regarded almost as a ‘yuman right’ in the credit-fuelled consumer societies of the developed world, the costs of that delusion will mount over the decades ahead. Worse still, the Government is actively encouraging young people to take on massive debts before they have any means of repaying them.

Even at today’s low rates of interest, debt that is allowed to accumulate on debt will often roll up faster than the debtor’s ability to repay it. For example, anyone who borrows £10,000 at a typical mortgage rate of 3.5 per cent will repay a total of very nearly £15,000 over the standard 25-year term.

Not many students today have heard of the ‘Rule of 72’ but more are likely to take an interest in future. This is the easy way of calculating how long it will take a debt to double; you just divide the annual rate of interest into 72 to arrive at the number of years. Albert Einstein is reported to have described compound interest as “the most powerful force in the universe” – and students in future could be forgiven feeling that questions about the accuracy of this quote are academic.

Sadly, savers have been so badly treated in Britain for so long that it is not hard to see why many have decided prudence is not worth the bother. Millions of people who set aside something for a rainy day in bank and building society deposits have seen the real value of their savings – their purchasing power – steadily shrunk by the Government’s undeclared policy of running negative real interest rates.

The average easy access savings account has lost nearly £2,500 of its real value or purchasing power during the last decade, according to calculations last year by Yorskhire Building Society. Inflation is the insidious enemy of savers because it stealthily reduces what their money will buy. But with the Government’s favoured yardstick, the Consumer Prices Index (CPI) and the Retail Prices Index (RPI) running in low single figures, many may underestimate the cumulative threat.

Simon Broadley of Yorkshire Building Society said: “With the average savings account standing at £11,648 this can have a significant effect on a person’s savings – especially over the long-term, given the current market.

“Over 10 years someone with the typical savings pot in a basic easy access savings account would have earned £1,624 in interest, leaving its nominal value at £13,272. However, for them to have the same spending power as when they invested – their savings would need to have grown to £15,700 – a difference of £2,428.”

No wonder Britain has turned from being a nation of savers to a nation of borowers. Regulatory requirements mean it takes hours to start a pension savings plan but just minutes to take out a credit card. After more than a quarter of a century of extensive and expensive regulation of financial services, the net effect has been to replace poor value retail savings products with even worse value retail credit.

http://blogs.telegraph.co.uk/finance/ianmcowie/100015239/britain-becomes-a-nation-of-debt-slaves-as-regulation-and-inflation-deter-saving/

WHAT WARREN BUFFETT SAYS ABOUT DEBT

Warren Buffet acknowledges that debt can effectively increase the return on equity in a company but warns against it. In 1987, he said this:

‘Good business or investment decisions will eventually produce quite satisfactory economic results, with no aid from leverage.'

'It seems to us both foolish and improper to risk what is important (including, necessarily, the welfare of innocent bystanders such as policyholders and employees) for some extra returns that are relatively unimportant.’

WARREN BUFFETT DOES NOT LIKE DEBT

Warren Buffett does not like debt and does not like to invest in companies that have too much debt, particularly long-term debt. With long-term debt, increases in interest rates can drastically affect company profits and make future cash flows less predictable.

• In 1982, Warren Buffett noted that Berkshire Hathaway preferred to buy companies with little or no debt and has repeated this mantra on many occasions. 
• He adopts the same philosophy for his company, preferring to avoid debt but where necessary going into it on a long-term basis only with fixed rates of interest and to obtain the finance before they need it.

Warren Buffett and Long-Term Debt

WARREN BUFFETT AND LONG-TERM DEBT

Warren Buffett speaks only generally of his approach to debt. Mary Buffett and David Clark have concluded that he focuses on long-term debt, a conclusion that is supported by his public comments. They believe that his concern lies with the company’s ability to repay its debts, should the need arise, from its profits; the longer the time period, the more vulnerable is the company to external changes and the less predictable are its future earnings.

The formula for such a calculation is:

Number of years to pay out debt = Long term debt
                                                 Current annual profit

COMPANY EXAMPLES

If we apply this formula to Johnson and Johnson, for example, we find, using Value Line, that for 2002, the long-term debt of the company was $2022 million and the profit for that year was $6610 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 0.3 of a year.

If we apply the same formula to McDonald’s Corporation, we find, using Value Line, that for 2002, the long-term debt of that company was $9703 million and the profit for that year was $ 1692 million. Dividing the first figure by the second, we can calculate that at that rate the company could pay off its long-term debt in 5.73 years.