There is, however, a healthy space between dower financial management and impulsive consumerism. Money can be enjoyed without guilt or fear.
This blog continues to explore the idea that financial literacy is key to bringing lasting change to dire financial situations. These situations can be as drastic as debt-based slavery or more everyday due to cost-of-living pressures. New Rivers is dedicated to making slavery obsolete and supporting families as they transition into a life beyond slavery. One of these supports is to provide opportunities for them to dramatically increase their financial literacy.
Financial training helps families who have been released from debt-slavery to understand how to manage their finances to reduce the risk of falling back into slavery. The financial management principles which are vital to these family’s survival are universally applicable. The principles we are exploring are: living within a person’s means, enjoying money, debt and creating margin. A recap on the principle of living within one’s means and enjoying money can be found at our previous blogs --> Part 1: Living Within One's Needs, Part 2; Enjoying Money. and correct figures
Good Debt, Bad Debt
This blog will focus on the fairly large and complex issue of debt. An understanding of debt needs to include an understanding of the difference of good debt and bad debt. This distinction will be examined within the example of the family circumstances we have been using in the previous blogs. We will return to the example of a family who has recently transitioned from debt-based slavery.
A family transitioning from slavery to low-wage employment is in a precarious financial position. They could end up back in debt-based slavery through circumstances outside of their control. Yet, by living within their means and by forming a habit of enjoying money they are strengthening their financial position each month that they put their financial literacy into practice. A brief summary of this family's financial situation, one month after they have begun earning day labour wages totalling 3,000 rupees per day (this example is based on a family who has been released from a brick factory in Pakistan), is as follows:
78,000 rupees/month income
20,000 rupees/month for rent in a communal setting
30,000 rupees/month for basic necessities (food, clothes, electricity and gas (for cooking and heating))
10,000 rupees/month for school fees
10,000 rupees/month for unexpected expenses (savings)
8,000 rupees/month for discretionary spending (enjoying money)
The family has spent 5,000 from the money set aside for unexpected expenses for some one-time purchases as they set up their household. They also have learned to enjoy their money so they have spent 8,000 rupees on things their family enjoys but could never afford when they worked as slaves. At the end of the first month, the family has 5,000 rupees in savings. The family is still in a very precarious financial position but their financial vulnerability will reduce month-on-month as they put their financial literacy into practice.
Debt is another challenge this family will need to address. Accumulating debt is not necessarily a poor financial decision. Whether accumulating debt is a good or a bad idea often depends on the following factors:
What will the debt be used to purchase?
What is the cost of the debt?
How will this debt affect the families overall financial position?
What Will the Debt Purchase?
How important is what the debt will be used to purchase? If this family borrowed 20,000 rupees for a meal at a fancy restaurant that purchase would not be very important. The family only benefits from the meal for one day at the most (aside from the memories they created - see blog on enjoying money). This debt would not have a long-term value and should avoided in most circumstances.
Alternatively, the children may need school uniforms, which cost 20,000 rupees, before they are allowed to attend school. The debt is connected to the long-term benefit of education and it is likely that the school uniforms will last the children for the majority of the school year. The family is receiving a benefit from the debt which will last for an entire school year. By comparison, the school uniforms are more important than a meal at a fancy restaurant.
The next question to ask when assessing taking on potential debt, like one for school uniforms, is “Will the debt last longer than what I am buying with the debt?”. Borrowing money to buy clothes may be appropriate if the debt can be paid back while the family is still wearing the clothes. The financial position of the family when their children started school was bleak. They had not yet earned wages for one month and so they had no savings. They could choose to forgo schooling until they could save up for the school uniforms, which at a savings rate of 5,000 rupees/month would take four months. The children would then have missed out on four months of schooling. The decision to delay their children’s schooling seems reasonable but would accumulated a 20,000 rupees have provided a better educational and potentially financial outcome for this family?
Cost of the Debt
The cost of the debt would need to be considered before the previous question can be answered. It is likely that the school uniforms could be purchased on a deferred payment system as it is unlikely that a state school would be in the habit of charging families interest. However, for the sake of interest as part of this family’s financial literacy this example will work on a 10% interest rate. Additionally, the family must repay the debt and interest within the current school year (10 months). The family must also make minimum monthly payments of 2,200 rupees (20,000 loan plus 2,000 interest (22,000 total loan cost) divided by 10 months). Helpfully, the family can pay off the debt quicker if they want.
After one month, the family decides to pay 3,000 rupees of their 5,000 rupees in savings towards this debt leaving them with 2,000 rupees in savings. The debt has now been reduced to 19,000 rupees. This family could continue to pay 3,000 rupees from their monthly savings of 5,000 rupees (the amount remaining from unspent contingency funds) as a way of putting their financial literacy into practice. In less than 8 months this family would have paid off the debt. Their children would likely still be wearing the uniforms after the debt had been repaid.
Effect on Overall Financial Position
Repaying this debt would have reduced this family's ability to save money since the majority of their savings went to service the debt. However, this sacrifice allowed their children to attend school sooner than would have been possible if they waited until they had enough money to purchase the school uniforms.
The family’s savings by the time the next school year starts and new uniforms are needed would be:
2,000 rupees from the 7 months they were making 3,000 rupees repayments on the loan; and
4,000 rupees for the 8th month when the final 1,000 rupees repayment on the loan was made; and
5,000 rupees for the last 2 months of the school year.
The family’s total savings would be 28,000 rupees which would be more than enough to purchase new school uniforms the following year.
Alternatively, the family’s financial position at the end of the year would have been stronger if they had not taken on the debt. They would have saved 50,000 rupees over the course of the school year and would have been able to purchase the school uniforms for 20,000 rupees (instead of the 22,000 rupees) after 4 months. At the end of the school term, they would have 30,000 rupees in savings and would also be able to purchase new uniforms at the beginning of the following year. The extra 2,000 rupees in savings came at the cost of 4 months schooling.
The above example demonstrates the benefits that can be gained by using debt to purchase items which are important. This type of debt needs to also come at reasonable costs which does not have a significant negative effect on the family’s overall financial position.
The next example demonstrates how using debt for an important purchase can have a significantly negative effect. Taking on this type of debt will make this family’s financial situation very precarious and bring them close to falling back into debt-based slavery.
Used Motorcycle
An opportunity presents itself for the family to purchase a used motorcycle for 200,000 rupees. This vehicle will allow the family to travel to work and school with greater ease. It will also give the parents the opportunity to increase their income through picking up extra jobs and being able to travel to a better job. There are also expenses associated with purchasing a used motorcycle like fuel, repairs and maintenance. Here is the breakdown on this debt and the costs and benefits associated with it:
220,000 rupees for the loan and 10% interest
Minimum monthly payments of 18,500 rupees
15,000 rupees in extra income for the family per month once maintenance, repairs and fuel are accounted for
There is a 3,500 rupees shortfall between the additional income and the monthly loan payments. This amount will need to be met using other parts of the family’s budget. The only available funds would be the 5,000 rupees they have saved from their budget for unforeseen expenses. 1,500 rupees in savings are left after making the remainder of the loan repayment. At the end of the year the family will own the motorcycle and have accumulated 18,000 rupees in savings. The following year they would receive 15,000 rupees/month in extra income when adding the monthly savings of 5,000 rupees which would amount to a total savings of 240,000 rupees. If the family had not borrowed money to purchase the motorcycle they would have 60,000 rupees in savings at the end of the year and 120,000 rupees by the end of the following year.
This example demonstrates the importance of understanding the fundamentals of debt in order to make good decisions. There are benefits for the family who purchased the motorcycle as their savings are larger than if they had not purchased the motorcycle. They also have the benefit of increased income in the year after they purchased the motorcycle. However, they have sacrificed time with their family as they pursued the additional income. Most importantly, they have kept themselves in a precarious financial position for longer than if they had not purchased the motorcycle. Their monthly savings were reduced to 1,500 rupees which meant that their capacity to deal with unexpected expenses was significantly less than if they had not purchased the motorcycle. Remember a key goal behind the financial literacy training is to ensure that this family does not return to debt-based slavery. Taking on a the debt for the motorcycle significantly increased the likelihood that this family would return to slavery within months of transitioning to low-paid employment. Taking on the debt for the motorcycle was not necessarily a “bad” debt but taking on this debt too soon was the problem with this choice.
Financial literacy is about providing tools instead of answers to the many financial options people face. These tools allow everyone, from former slaves to those in OECD countries who are facing cost of living pressures, to make wise decisions about their finances. Approaching debt with financial literacy tools reduces the risk of taking on debts which are not important, too costly or which will negatively affect your overall financial position.
This series on financial literacy will be concluded in our next blog which discusses the idea of creating margin.
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Pictured: Manfred, Michelle (centre) and the New Rivers Team
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