Debt. Friend, Foe or Frenemy?
Debt. The very word is enough to send the sun scurrying behind the clouds and shivers running up and down your spine.
And yet, the overwhelming majority of UK adults, businesses, and indeed many of the world’s governments, depend on debt to operate.
For example, as a nation, by the end of February 2015, adults in the UK owed a staggering £1.471 trillion to creditors. Our mortgages and credit cards alone have created an average household debt of over £55,000 meaning many of us owe more than we earn in a year.
Businesses and Government are in on it too. The UK Government borrowed over £2500 per second in February 2015. Whilst businesses routinely fund growth and ease cash flow by taking on debt in the form of bank loans, overdrafts, lease/hire purchases or bonds. *
We’re all at it, using debt every day to make things better and easier. All of which makes debt a confusing thing.
It is our foe because as we all know it costs more to borrow than the amount borrowed in the first place. And without careful planning and management, debt can easily run away from us with potentially catastrophic results.
Yet, it is also our friend, enabling us to do things we might otherwise not be able to do. Things that benefit us in other ways, like holidays to de-stress, a start-up loan to get a business off the ground, or a cash injection to keep the NHS working.
And, there is another way in which debt can be our friend. When we, as consumers become the lenders rather than the borrowers. By lending to businesses we make the interest, rather than having to pay it.
Making Money Out of Debt
The world of business lending has, until now, been owned by the City. With its jargon and complex dealing markets, it's a world few of us can hope to penetrate. Made up of niche specialisms with incredibly sophisticated and nuanced practices, even those who work in the money markets rarely claim to understand it in its entirety.
However the advent of crowdfunding and peer-to-business (P2B) lending is opening up this world. So if you’re interested in trying it out to see if you can make your money work for you, here are some basic things to consider first:
1. What is your risk tolerance?
Almost all investments carry risks. As a general rule of thumb the higher the expected returns, the greater the risks. And you need to understand what level of risk you are able to afford. Think about the financial impact of losing all of the money you lend to business(es) and decide if you can afford this.
This amount will be your risk tolerance, and you should not lend any more than this at any one time.
2. Protection not prevention.
Investment products, including lending money to businesses, are all designed in different ways and this is called its structure. Structure is extremely important, it is this that determines what protection your money has. No investment is devoid of risk, so protection is about limiting the possibilities and impact when things go wrong, not eliminating them.
Protection comes in various forms. Such as having the ability to sell part or all of your investment/loan to a third party and thus exiting the investment early if needed (although of course you also cease to benefit from the returns if you no longer hold the investment). Or your investment might be secured against assets that can be sold to raise cash in the event of the business defaulting. This is great, but you also need to know where you would be in the queue of creditors to understand the likelihood of recouping your money in these circumstances.
Look for investment products that are structured in ways that help protect your money.
3. What will your money be used for?
As with our personal finance, how we spend any money we borrow can determine our ability to pay it back. If we use it sensibly, it can add value for us but used badly we may have difficulties in repaying it. Think about it this way, if you borrow money to go on holiday, you know you’ll need to do something else to earn the money to repay the loan. If you borrow money to start a business venture, you hope the business venture itself will not only earn the money to repay the loan but will also create extra profit for you.
To be sure that the business you are lending money to is more likely to be able to pay you back, plus interest, find out how the money you are lending will be spent. And throughout the period of the loan, make sure you have access to the up-to-date information you need to see this is happening.
4. Are there any other restrictions that might help protect your money?
A lender can insist how a borrower spends the loaned money. For example, if you get a mortgage you have to use it to buy a property. If you get a car loan you have to show you have spent the money on buying a car and not just blown it on a holiday to the Caribbean!
These are called restrictions and you can also look for these when finding a loan product enabling you to lend money to a business.
5. Have you looked at the tax implications or charges?
Headline interest rates can be very attractive, but also misleading if you then find you have to pay tax and investment fees. Before deciding to invest calculate the amount of money you will actually make by deducting any costs from the amount you should be repaid in interest.
And of course, your returns will be better if the investments can be held tax-efficiently, now or in the future, in the form of ISAs or SIPPs.
6. Lastly, but perhaps most importantly – who are you lending to?
Debt is essentially an IOU, and the quality depends heavily on the company and the people borrowing the money.
In the City where banks and institutions lend money all the time, experts assess a business based on its financial health – a bit like a high street bank does when we apply for a mortgage or a credit card. They’re looking for a good balance sheet (essentially a snapshot of the company's assets minus their liablities). Also they look at cash flow. A good business with strong management of its finances will ensure it always has enough money in its accounts to pay its bills. Before investing in a business you need to look for evidence suggesting it is financially healthy and competent.
And it is also about people. Who’s in charge of the business? What is their personal track record, their history and experience? Can you see evidence suggesting the management team will be able to handle and use the money you’re lending them wisely? You wouldn’t lend money to a friend you consider to be irresponsible and expect to be repaid. So don’t lend money to businesses unless they can prove they are responsible.
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For more information on P2B lending as a form of investment check out the FCA website and their guide to crowdfunding here.
* data in this article has been taken from the Money Charity annual debt survey April 2015.