Like death and taxes, debt is somewhat inevitable. We all will likely encounter it in some form or another during our adult lives.
Perhaps it's the credit card bill after an overseas holiday, a car loan, or the HECS loan used to finance university studies. It could be the mortgage on your house or even just a plain old IOU with a friend.
In many cases, debt can be helpful. It means we can afford a roof over our heads or a sweet ride. Or the education required to get our dream jobs.
But debt can also be suffocating.
Homeowners will be familiar with the dread of watching interest rates creep up while wondering how to afford their ever-increasing mortgage repayments. But even those who don't own their own homes will probably still be familiar with the panic of opening an unexpectedly high credit card bill!
If you have high levels of debt, it makes it much harder for you to grow your wealth. More of your money will have to go towards servicing your debt, reducing your capacity to save and invest. In a worst-case scenario, this can force you into a debt spiral, where you must take out even more debt just to cover your existing loan repayments.
When your debt gets out of control like this, it negatively impacts other aspects of your life. Constantly worrying about how you can afford to make your next repayment can cause high levels of stress and anxiety – and it can even put a significant dent in your self-confidence.
But debt doesn't have to be scary.
Putting in place the techniques and strategies to properly manage your debt ensures that you always remain in control of your debts – and they don't end up controlling you!
In this article, we help you understand what debt is – including some of the most common forms of household debt, like credit cards and mortgages. We will also look at some of the steps involved in effective debt management so that you can efficiently deal with your debts (and hopefully even stay debt-free!).
Understanding debt
We can use debt to finance all sorts of things, from everyday retail purchases to homes, cars and education costs. It can be structured in different ways, depending on the type of purchase the debt is intended to finance. For example, a home loan usually has a longer term and a lower interest rate than a short-term personal loan designed to finance a holiday.
Below, we take a closer look at the most common forms of debt people encounter in their daily lives.
Credit cards
Among the most recognisable forms of debt are credit cards. Issued by a bank or other financial services company, you can use these cards to make purchases up to an agreed credit limit. These little pieces of plastic are ubiquitous these days, especially as we become an increasingly cashless society. Some are even entirely digital, stored on peoples' smartphones.
The way a credit card works is relatively straightforward. Instead of using cash, you can charge your purchases to your credit card. Then, at the end of the monthly billing period, the credit card provider will require you to repay whatever you owe.
You can either pay back the card in full or make at least a minimum repayment against your total balance. In exchange for giving you this line of credit, the provider will charge you interest on your purchases and any other ongoing account fees.
In some cases, credit cards can be a useful way to make purchases – particularly if you pay off the full amount owing at the end of each month. Some credit cards also allow you to earn rewards for making purchases, such as frequent flyer miles and other loyalty benefits.
However, credit cards also usually charge much higher interest rates than other types of loans. This makes them particularly dangerous – and pernicious – forms of debt.
Car loans
Another common form of debt is a car loan. This personal loan is used to purchase a new or second-hand car, usually for a fixed term of one to seven years.
Car loans – particularly for new cars – are typically 'secured' by the vehicle itself. If you can't repay and default on your loan, the lender can repossess your vehicle and sell it to cover their costs.
You can also take out an unsecured car loan, although these are less common. The rate charged on the loan will usually be higher, and the lender probably won't let you borrow as much. Unsecured loans may sometimes be used to purchase cheaper second-hand cars.
One particular thing to be wary of in a car loan is that some include a 'balloon payment' at the end of the loan. Although this reduces your monthly repayments on the loan, it often leaves you with a large lump sum to be paid off (with interest) when the loan term ends.
Car loans can also come with a fixed or variable interest rate. With a fixed-rate loan, your repayments will be unchanged over the term of the loan. This can help with your personal budgeting, as you will always know your monthly repayments.
In a variable-rate loan, the size of your loan repayments can vary depending on prevailing interest rates. You don't have to pay as much interest on your loan if rates go down. Of course, if rates go up, then so do your repayments. This can make variable-rate loans riskier than fixed-rate loans, although they can reduce your repayments in a falling-rate environment.
Mortgages
For most of us, our homes are the largest single purchase we'll make. No wonder then that home loans account for the bulk (about 56%) of household debt in this country.1
A loan used to finance a house is known as a mortgage (from the old French for 'death pledge' – I'm sure homeowners can relate). In a mortgage, the property serves as security for the loan.
Just as a car loan allows you to buy a vehicle without paying the total amount upfront, a mortgage enables you to buy a house with a minimum deposit. You borrow the rest of the money from a bank or other financial institution and pay it off over time.
Most lenders will require you to make an initial upfront deposit of at least 20 per cent of the property's value – meaning they will lend you the other 80 per cent. Some lenders will accept a deposit as low as 10 per cent, although this might come with a higher interest rate (and you'll also be charged lenders mortgage insurance to cover the increased risk of default).
Given mortgages are usually for substantial sums of money, the loan terms are generally quite long (around 30 years). As with other personal loans (like a car loan), you must pay off the principal (the amount you actually borrowed) and interest on the principal.
Some lenders offer interest-only periods, where you are only required to pay the interest without making any principal repayments. While this can provide some tax incentives for investment properties, it will usually result in larger overall repayments over the life of the loan.
And – just like with car loans – you usually have the option of a fixed or variable-rate mortgage. In a fixed-rate mortgage, the rate is usually locked in for up to five years. At the end of the fixed rate period, your mortgage will usually revert to the variable rate – but you will have the opportunity to refinance your mortgage to see if you can find a more competitive rate elsewhere.
The real cost of debt
Here at the Fool, we bang on a lot about the magic of compound interest. It can be a fantastic way to grow your wealth over time, making you far richer in retirement.
Essentially, 'compound interest' means you earn interest on your interest, so the longer you leave your wealth to compound over time, the greater the returns you can earn.
But the dark side to compound interest is that it also applies to your debts. As you accrue interest on your debts, these too attract interest, quickly increasing both the repayments on your debt and the amounts you owe. This is how you can find yourself in a debt spiral, where your debt increases beyond what you can afford to pay – a pretty scary prospect!
The real cost of debt eats away at your wealth potential. When an ever-increasing amount of the money you earn is going towards repaying your debts, it means you cannot save and invest.
So, not only does your debt increase, but you also miss out on the potential compound returns you could otherwise earn if you saved your money instead of giving it straight to your creditors. So, your debt actually hurts you twice over!
Steps for effective debt management
You can effectively manage your debts in many ways – some of which may be unique to your circumstances.
If you encounter serious debt issues, it's always best to speak to a professional – like a financial advisor or financial counsellor – who can work with you to tailor a financial plan that best suits your needs.
However, here are some broad steps to follow in a successful debt management plan:
1. Assess your debt
The first thing to do is be honest about how much debt you owe. This can often be a sobering prospect, but it's a vital step in dealing with your debt once and for all.
Be sure to include all your debts – including your mortgage, credit cards, car loans, HECS-HELP debts and any other loans you are responsible for.
It's also a good idea to include the interest rates charged on each of these and how much the monthly repayments are. This can help you in your next step… prioritising repayments.
2. Prioritise repayments
In this step, you work out the order in which you want to pay off your debts. Not all of your debts will be the same – some will charge higher interest rates (like credit cards), while others will be longer-term and more predictable (like a fixed-rate mortgage).
This means that it can be financially (and psychologically!) beneficial to pay off some debts ahead of others.
You can use different methods to work out how to prioritise your debt repayments. Under the 'snowball method', you would start by prioritising your smallest debts first while making just the minimum repayments on your larger debts.
Once the smallest debt is repaid, you move to the next smallest, taking the money you were using to repay your smallest debt and adding it to the minimum payment you make on the second smallest, and so on. In this way, your repayments snowball, becoming larger and larger, while your debts decrease more rapidly.
The 'avalanche method' takes a similar approach to the snowball method but prioritises debts with the highest interest rates first. Once the debt with the highest rate is paid off, you would move to the second highest, and so on, adding to your repayments as you go.
This method is more likely to save you money over time because the loans with the highest rates carry the greatest financial burden. However, this method doesn't always make sense if the principal on your higher-rate debt is larger, as you can get bogged down repaying that without addressing your smaller debts.
You might also consider consolidating your debts if you have many different debts (like multiple credit cards, for example). Debt consolidation usually means taking out another personal loan and using that to pay off your other debts. That way, you now have just one single loan to repay, with a single interest rate, rather than multiple smaller debts that may all charge different interest rates.
While debt consolidation can make budgeting easier and give you some peace of mind, it may not be the best solution in all circumstances.
If the rate on the new loan ends up being higher – or the loan term is longer – you may still pay more in the longer term. When deciding whether debt consolidation would be right for you, consider any additional fees you would have to pay on the new loan.
3. Create a repayment plan
Once you've assessed your debt levels and come up with a method to prioritise your repayments, it's time to devise a repayment plan. In this step, you should calculate how much of your income you can devote to paying off your debts.
The best way to do this is to create a weekly or monthly budget. Compare your total income with all your regular expenses, like rent, groceries, utilities, transport costs and spending on things like clothing and going out. Be honest with yourself about your spending. Otherwise, you won't be able to develop an accurate budget.
Once you've estimated your total costs, see if there are things you can cut back on (at least in the short term). Continue until you get to the point where you maximise the amount by which your income exceeds your costs. This difference is the money you can put towards paying off your debts.
The more money you can afford to devote to your debt repayments, the faster you can repay your debts – but you should still be honest (and realistic) about what you can cut back on. Otherwise, you're only setting yourself up for failure.
You should speak to a financial counsellor if you cannot reach a point where your income exceeds your costs. The National Debt Helpline is a great resource and provides free financial counselling – the number is 1800 007 007.2
4. Negotiate with creditors
This step is so important that our Chief Investment Officer here at the Fool, Scott Phillips, even came up with a hashtag for it a few years ago: #getabetterrate.
He encouraged everyday Aussies to share their stories about how they 'spring cleaned' their finances and reduced the interest repayments on their loans – simply by contacting their creditors and negotiating a lower rate.
A vital step in any debt management plan is understanding the interest rates being charged on your loans (particularly your mortgage).
If you're getting a bad rate, see if you can negotiate a better one, or even switch to another lender. And if this sounds a bit daunting or complicated, financial counsellors can assist you with this process.
Avoiding future debt
Setting up an emergency fund to cover any unforeseen expenses (or a loss of income), as well as separate accounts to save up for things like holidays or other large personal purchases can be a great way to ensure you don't go into further debt.
If you get in the habit of saving up for your purchases, you won't need to rely as much on loans, especially credit cards, to help finance the lifestyle you want.
And if you do use a credit card for everyday purchases, try to make sure you pay off the full balance each month, to stop your interest payments getting out of control.
Although it might not feel like it at the time, the best financial decision you can make is to pay for your purchases using money from your own savings rather than taking out more debt. Be honest with yourself about what you can afford within your budget – but set up separate savings accounts so that you can still splurge on luxuries every now and then.
Foolish takeaway
Oftentimes, taking out debt can be the only realistic way we can afford large purchases. Very few people have the cash available to buy their own cars, homes or education outright.
But taking on too much debt can be dangerous – especially if it is very expensive, like credit cards or short-term personal loans. Not only do you limit your ability to grow your wealth, but in a worst-case scenario, you might even be caught in a debt spiral.
This can have negative psychological impacts, causing you untold stress and anxiety – and often hurts your self-confidence and sense of financial independence.
The best thing you can do to stay on top of your debts is to set up and regularly review a debt management plan. Continually assess your debts, prioritise repayments, and develop an achievable repayment plan.
And maximise the benefits when you are debt-free by investing your money or saving it in an emergency fund. This will help you avoid debt in future and give you peace of mind, knowing that you are in control of your debts – and they aren't controlling you!
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