Financial planning can often seem complex and feel overwhelming, causing many to avoid taking advantage of financial tools that could help them achieve their financial goals faster. When most people hear the word debt, they think of financial burdens and stress. However, debt isn’t always a bad thing. When managed responsibly, it can be a powerful tool for building wealth and accessing opportunities otherwise out of reach.

What is Debt?

Debt is money borrowed that must be repaid, typically with interest. Common examples include home mortgages, car loans, credit card balances, student loans or payday loans. While debt often has a negative connotation, it is important to realise that not all debt is equal. Understanding the difference between unproductive debt and productive debt can make a significant impact on your financial journey.

Unproductive Debt vs Productive Debt

Unproductive debt typically involves borrowing for purchases that quickly lose value or do not generate income or long-term financial benefits. This type of debt can often come with high interest rates, making it harder to repay and potentially hindering financial progress. For example, using credit cards to cover daily expenses or luxury items without the ability to pay off the balance promptly when due can lead to high-interest charges that accumulate quickly. Unproductive debt often does not align with your financial goals and can limit your ability to save, invest, and build wealth.

Productive debt, on the other hand, is money borrowed to invest in assets or opportunities that have the potential to increase in value or generate income over time. Examples include taking out a mortgage to buy a home, investing in education to enhance your earning potential, or securing a loan to start a business. Productive debt can be a strategic tool for achieving long-term financial goals and building wealth.

Understanding the Role of Interest in Debt

Regardless of the type of debt, all debt comes with interest — the cost of borrowing money. Interest rates can significantly impact how much you ultimately repay and how quickly you can achieve your financial goals. Understanding how interest works is essential to managing debt effectively. Before taking on any debt, always check the interest rate, as it should guide your borrowing decisions. Lower interest rates make borrowing more attractive for wealth building investments, while higher rates can often be a deterrent and make debt more burdensome. Being aware of the interest rate terms can help you make smarter financial choices, save money, and reach your goals faster.

There are various types of interest, but here we’ll examine three major ones that are most commonly encountered: compound interest, reducing balance interest, and flat/fixed rate interest.

Compound Interest

Albert Einstein once referred to compound interest as the “eighth wonder of the world”. Compound interest is the interest calculated on both the initial principal and the accumulated interest from previous periods. This can significantly boost your savings and investments, making it a powerful tool for wealth building. However, compound interest can also work against you when applied to certain debt. For instance, if you carry a balance on your credit card, interest is added to the principal balance and this new balance then becomes the base for calculating future interest, thus creating a compounding effect and increasing the total amount owed. This compounding effect partly explains why Jamaica’s credit card debt reached over J$800 billion in 2023, as many cardholders find themselves paying only the minimum amount each month, with interest costs eroding their ability to save, invest, and build wealth. However, by understanding and managing how compound interest works, you can use it to your advantage.

Reducing Balance Interest

Reducing balance interest, also known as the diminishing balance method, calculates interest on the outstanding loan balance rather than the original principal amount. This method is commonly used for car loans, personal loans, or loans for depreciating assets. With each repayment, the principal decreases, so the interest portion of each subsequent instalment also decreases. This means that borrowers pay less interest over the life of the loan compared to other interest methods. It is important to note that the reducing balance method benefits borrowers who can make regular payments or even pay off their loans faster because the interest savings grow as the principal decreases. Therefore, if you make additional payments toward the loan principal, it can reduce overall interest costs significantly, leading to shorter repayment periods and more money saved.

Flat/Fixed Rate Interest

A flat or fixed rate interest is a simplified interest rate that is set at the beginning of the loan based on the principal and remains constant for the life of the loan. These rates are usually unsecured and don’t extend beyond five years. Flat rate interest provides stability with fixed monthly payments, making budgeting easier, especially for those on a tight or fixed income. However, since the interest is calculated on the total principal amount throughout the loan term, borrowers often end up paying more in interest compared to reducing balance methods.

Additionally, some flat-rate loans in Jamaica like those used for mortgages, may start with a fixed interest rate for an initial period (for example, three years) and then shift to an adjustable rate for the remainder of the term loan. After the initial three years, the interest rate is adjusted to match the current market interest rates and remain at this new rate for the next three-year period. These adjustments continue at regular intervals throughout the life of the loan. In times of economic uncertainty, individuals with adjustable-rate loans may experience increases in their monthly payments, affecting affordability. Therefore, in an inflationary environment, borrowers should consider whether their loan’s flat rate interest is helping or hurting their finances. If the rate is locked in at a low level, borrowers benefit by paying less than the current market rate. However, if the rate adjusts upwards, borrowers could face higher payments that put additional strain on their budgets.

Bottom Line

Debt can be used to your advantage allowing you to access investment opportunities and assets that would otherwise be out of reach. This includes purchasing property, investing in a business opportunity or investing in stocks. By minimising unproductive debt and leveraging productive debt, you can transform liabilities into wealth-building opportunities when managed wisely. Before taking on debt, it’s crucial to understand the type of interest and how it impacts you as the borrower, ensuring that the debt aligns with your financial goals. Of course, when making a decision to use debt to growth your wealth, it is also important to do the analysis to ensure that, among other things, the return potential on the asset to be financed with debt is higher than the cost of the debt (interest rate) and that you have the ability to service the debt. For personalised advice, consider speaking with an NCB loan officer to learn more about your loan options and a wealth advisor from NCB Capital Markets Limited to explore wealth-building strategies for you.