Debt reduction and financial freedom.

Debt Reduction

Debt reduction may be high on your list of priorities if you’re one of the increasing number of people with high personal debt.

Around the western world, levels of personal debt are at record highs – largely driven by the power of consumerism, the use of credit cards and more easily attainable loans through sometimes ‘predatory’ lenders.

Don’t get me wrong – debt is not a bad thing, but the ‘type’ and ‘level’ of debt you’re in might be. The important thing is to understand your debt and have a strategy for paying off your debts by having debt reduction goals.

What is good and bad debt?

The concept of investing is that to make money, you need to spend money. Many people actually borrow money [and therefore go into debt] to put into investments such as shares and even managed funds.

This is “good debt” because it is off-set by your return on investment – provided of course, you picked a wise investment!

Other examples of ”good debt “ are house loans, because your house is also a valuable asset in your wealth portfolio and car loans – although cars depreciate in value, they are usually essential for getting to work, etc. and therefore considered a part of acquiring wealth.

Student loans, debt incurred in the course of developing your career and business loans are all considered to be good debt. In fact, you may even be able to claim the interest component of business loan repayments as a tax deduction – but check this with your tax accountant first, as rules differ in different countries.

Hence, good debts can be described as debts that help you build wealth.

Of course, good debts are only ‘good’ if they are for the right investment, the right house and the right car for your needs and repayment ability. Many people are paying off loans for failed investments.

Bad debts are loans or credit with no tangible 'asset’ or for an asset of little value – for example, taking out a personal loan for a holiday is considered bad debt as you have not accumulated any wealth from it. And taking out a loan for an 80 inch plasma TV is also bad debt as it depreciates in value (like a car) but unlike a car, doesn’t help you build wealth.

Debt that arises from the over-use of credit cards is also bad debt as this debt typically arises from lots of small purchases with no value.

Hence, bad debts are those that don’t help you build wealth. What debts do YOU have? How many of these are good and how many are bad?

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Understand your debts

You need to understand your debts as the first step to be able to come up with effective personal debt reduction goals.

Debts are simply amounts of money that you owe to a financial institution – whether that be a bank or non-bank lender. Debts can arise from personal loans, house loans, credit cards and in-store finance cards.

The cost of the debt to you comes from the interest rate of the loan or credit card. For example, if you have a personal loan for $10,000 at an interest rate of 12%pa, every year you pay 12% of the amount remaining on the loan to the lender - $1200 in this case. This is the cost of the loan to you.

The higher the interest rate on the loan or credit card, the higher the cost to you.

In general, house loans have the lowest interest rate because you typically borrow a large amount. Personal loans are next followed by credit cards and in-store cards – and some of these have interest rates in excess of 20%!

In understanding your debts, it’s also important to understand who the debt is with.

Banks are the most conservative in issuing loans, as they consider your ability to repay’ in their assessment of your loan application. If they don’t think you can repay the loan, they won’t give it to you!

If you are in this situation, be very very careful about getting a loan for the same amount from a non-bank lender as they are less concerned with your ability to repay – there are more repossessions from non-bank lenders for this very reason!

Prioritise your debt reduction

Debts with a higher interest rate cost you more money than those with a low interest rate.

Your priority for your debt reduction goals therefore needs to be to pay off the loans with high interest rates first. And these loans are usually for bad loans, since lenders won’t give good rates where these is no asset they can repossess if you fail to make payments.

This usually means pay off your credit card and in-store cards first, then personal loans (including car loans) and then house loans.

Business loans, particularly if there is a tax off-set allowed, can be paid off last provided the ‘business’ is in good shape!

A note regarding the in-store loans where they offer no interest, no repayments for 12 months or so: These are useful forms of credit if you manage them properly. And the way to do that is make sure you pay the loan off over the “no repayment” period.

For example, if you take one of these loans out for $1200 for a 12 month period, every month pay off $100 from the loan. That way when the interest kicks in {and this interest rate is usually high}, you’ve paid it off anyway.

Avoid more debt

Of course, not letting yourself get into excessive debt is the best way to manage your debt and should form part of your debt reduction strategy. So consider the following tips:

Avoid bad debt – if you can’t afford that plasma TV, don’t get it! Save up for it instead.

Don’t be tempted by In-store finance – even if it’s interest free and no repayments for 12 months, unless it is something you really need, don’t get it. It’s better to save up the money and then negotiate a better deal for paying cash. So debt reduction and savings go hand in hand.

If you do take up an in-store finance offer, fully pay off the debt during the interest free/ no repayment period so it doesn’t become a big debt once the interest charges start.

Be very careful with credit cards – they are very convenient for groceries and paying bills, but the risk is you spend more than your budget. If you normally take $100 cash to do your groceries, then don’t spend more than $100 with the credit card.

Only use credit cards for your day to day purchases and NEVER use them as credit for a ‘loan’ – they attract huge interest rates and it will cost you heaps.

Always pay off your credit card bill every month to make the most of the interest free period and so you don’t get charged interest for your groceries!

Only go into debt as much as you can afford to repay. Don’t be tempted by non-bank lenders if a bank has turned you down based on your ability to repay – they do this for a good reason and you should think very carefully about whether you can really afford to make loan repayments.

Remember that debt is not bad, it’s all about how you manage it - and this should be the focus of your debt reduction goals.

There is a debt record sheet in the ToolBOX under the section on Financial Tools you can use to track your debts. You can also use the Saving Plan in the ToolBOX as part of your debt reduction goals.