Love it or hate it, just understand it before it kills your wealth
At some time in our lives, (usually early on) debt is unavoidable, especially for high ticket items like houses or cars. Depending on how you were brought up, it was either dead easy or as scary as hell. As time goes by we get used to it, so the next debt we take on is easier, and if we’re too complacent or have a run of bad luck then it can spiral out of control. Debt isn’t just a number on your balance sheet, it often has a physical effect on you. Obviously it is going to depend on your risk appetite, but usually, the more debt the more stress you take on. Some people relish in that stress, but they are in the minority.
We are often sent mixed signals about debt, especially if we are in business. ‘Leveraging’ (which is just a fancy word for debt) is seen as ‘smart’. “Use other people’s money” we’re told over and over, so how do we fix our relationship with debt, get it into perspective and understand ‘good’ and ‘bad’ debt?
For a start, if you’re in business and you have limited liability then leveraging your business is often smart and necessary so you can gain critical massJust be aware that banks have cottoned onto this ‘limited liability’ and directors now have to sign personal surety for any ‘accommodation’ (yet another euphemism for debt) you’re given (read the small print). They prefer it if that surety is backed up by a physical asset too of course so if you don’t pony up when they ask, they can just take your house. Lose/lose much?
Being in debt early on in your life is like being on diet, you can’t eat nothing or you will die, so you have to find a happy balance. Of course, everyone’s balance is going to be different, but again, like weight, there is going to be an ‘acceptable’ zone. If you decide to have zero debt ever (and don’t have a trust fund to live off) then you may wait decades to get onto the property ladder. Owning your own home is not a necessity, far from it, but let’s look at when it is sensible, and when not. A mortgage bond is made up of two components, interest and capital. These days even the banks will split this up on your statement. The interest is rent, the capital is your investment. If you rent, then your payment should not exceed the interest portion of a new bond. Why a new bond? As time goes on, capital is built up in the asset and the interest portion comes down until the last few years when it is almost all capital/investment. As a landlord you usually want the tenant to pay off the entire bond, interest and capital, and more often than not that is what happens. A landlord will justify the rest as ‘risk’, with good reason. Regulations are not landlord friendly and defaulting tenants are on the rise. So, basically, if your rent is more than the interest on bond you could get on that property you should get your own. Having your own rental property is a whole different topic, but you can read about it on my blog HERE (or HERE or HERE – it is a pet topic of mine).
When deciding what is good and bad debt there are two things to take into consideration, the interest you’re paying on that debt and what percentage that debt is of your annual income. It is also important to read the small print in that debt agreement and make sure you’re not tied into something for years with no escape clause (without penalties). If you’re unfamiliar with ‘cheap’ or ‘expensive’ debt it’s time to do a bit of research – it will only take minutes but will save you thousands in the long term , thousands that you could be ploughing into your wealth.
The Reserve bank sets the ‘repo rate’, at the moment it is 7%. Prime interest rate is usually 3.5% above this, i.e. 10.5%. That is the bank’s ‘margin’ aka profit. One can usually get a ‘prime’ interest rate on a mortgage if your deposit or equity is more than 80%. Do you know what yours is? Credit card debt is usually around 18% which is clearly ‘expensive’ and should be avoided at all costs. Personal loan interest rates can get much higher than this – up in the high 20%s, and payday loans as much as 500%.
It’s not rocket science. If you already have debt that is above prime, pay it down as quickly as possible, ideally, the only debt you should have is a mortgage bond. Use credit cards, don’t let them use you. Take advantage of the zero swipe fees and no interest for 55 days on your credit cards to keep your total costs down, but pay them off 100% by the due date. If you have more than one credit card, pick the one with the highest interest rate to tackle first and pay it down to zero, and so on. In my opinion, one only needs two credit cards, max. One Visa and one Mastercard (and then only if you travel so you’re not left stranded in a foreign country because one or the other merchant is ‘down’ – common in the East.) You might be lured in by loyalty programs, but pick your poison. Almost all cards have a steep annual fee that usually wipes out any loyalty benefits.
Paying down the most expensive card first is ‘common-sense’ but doesn’t take human behaviour into account. We are often most encouraged by ‘small wins’, so paying off the smallest debt, irrespective of the interest rate, often has a better result because we are encouraged to stay the course. Because of subdued demand, one can often get cars at low interest rates too. This is usually the second largest debt in the family budget, and if you’re smart, only applicable to your first car. Cars are not an investment, they lose 20% of their value the second they are driven off the lot, and just continue to lose money thereafter. Car manufacturers love it when you trade in your car every 3 years, and play on your insecurities once the car comes out of ‘motor plan’. Don’t get sucked in by that nonsense (nor use it as an excuse to justify your physiological or ego ‘need’). If you take the repayments you were making on the car and invest them once the term is up, you will not only pay for any future services and maintenance but have more than enough to replace that car when it really does become a liability, usually around 10 years old. If your friends, colleagues or clients judge you by the car your drive, understand that it is they that have a problem, not you.
How can you tell if your debt is good or bad? One way is to look at what ‘return on investment’ you could get if you invested that money – in money market, bonds or equity. A five-year fixed deposit might get you around 8.2% at the moment. Equities for the last two years have been pretty dismal, so if you’d invested in an ETF (for example) you’d have got a couple of percent in return. If you’ve been lucky enough to have invested in a portfolio of mixed assets with a good asset manager you might have got 11%, before fees. In this low growth environment, it makes sense to pay off all debt, including mortgage bonds as fast as possible. It is the ‘best’ return on investment you’re going to get. Once asset growth rates increase above 12%, then that money would be better invested in the market.
One word of warning – be careful how much debt you take on, especially in a mortgage bond. You might be able to afford it now, and the bank might give it to you, but will you able to afford it if the repayments double? Impossible for it to double? Have a look at the graph below and think again, remember the banks add 3.5% to repo.
Action: Have a small excel spreadsheet to keep an eye on the interest rate you’re being charged by the financial institution, your outstanding debt, repayments, loan term. Like the one below perhaps. Have a strategy to clear it, whether the smallest one first or most expensive, then monitor it monthly. It might make sense to consolidate your debt in a mortgage bond, even if it costs a couple of thousand to increase your bond or move it. Have a clear strategy for your debt, and when you’ve reached your objective, don’t take out any more.