Monday, June 12, 2006

Decisons on Debt #1

Debt is something that provokes very different feelings in different people. For some, it is a burden - an obligation that needs servicing and an obstacle to many other things. For others it is a wonderful tool that can be used to build wealth or achieve an objective sooner than if debt were not available. For many it is a bit of both.

Most of us will face at least two important questions about debt in our lifetimes (often on several occasions):

1.should I use debt to acquire something or to do something?

2.if I have surplus cash available, should I use that surplus cash to repay debt or to invest?

Evaluating these questions is not always a straight forward exercise. It goes beyond simply pulling out a calculator and punching in some numbers. The key factors to take into account in reaching a decision are:

1.what are the range of expected financial outcomes from my decision?
2.what assumptions did I make in predicting the range of expected outcomes?
3.what are the risks to those assumptions?
4.what is my risk tolerance - how will I react if things do not go according to plan?

Only one of these four factors involves a mechanical calculation. That is the easy part.

Two involve assumptions. Assumptions by their nature are not certain facts. They are either guesses about unknown present or past facts or predictions about an uncertain future. No one (least of all me) can predict the future with any degree of certainty. Also, I know that my predictions will be subject to bias as a result of my past experiences, near term external influences and other factors that I may not even recognise.

The last factor also involves looking into the future and thinking about how I will deal with the situation if things go wrong - both financially and emotionally. Put differently, what is my risk tolerance?

In conclusion, decisions on whether to take on or repay debt are not matters of simple calculation and, very often, non-financial matters can have a significant, if not decisive, influence on the decision making progress.

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