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As the recent Global Financial Crisis (GFC) has shown us, debt (or Leverage) can be a double-edged sword. It is great for funding expansion or purchase of revenue generating assets - but when the value of those assets (in the case of the GFC - US Housing) suddenly reverse, you have the nasty case of owing the bank more than the asset is worth (Negative Equity).
Servicing debt (ie - making repayments including principal & interest) can quickly grow out of hand in some households and can, in some cases, lead to bankruptcy (which nobody wants!).
So here is a quick & easy guide to get you back on track if you are experiencing difficulties with debt.
Step 1
What is your current position now?
a) List all your debts - including - home mortgage, car loans, personal loans, margin loans, credit cards - basically anything where you owe somebody money
b) List all your assets - keep this to assets which could realistically be sold to generate cash - including - house (most recent valuation), investment properties, cars, boats, superannuation, cash in bank, shares, bonds, managed funds, savings accounts, money you are owed etc
c) Now minus your debts from your assets - what is the amount? If this is a negative figure you are Insolvent - this is NOT good. Fix yourself a stiff drink and then when you sober up - go and talk to an accountant. However, in most cases you should have positive equity.
d) Now, list all your debts and the interest rate for each one.
e) Create an additional column to show which debts are tax deductable. This will depend on which country you pay tax in, however in general, any debt which is used to generate taxable income is tax deductable. This would include - investment property loan, margin loans, loans for your personal business etc
f) Now add up all your income and expenses each month - this should also be a positive amount - if not, you need to reduce your expenses or sell some assets. See more tips later in this blog...
Step 2
Prioritise your debts so that you concentrate on paying out or reducing in this order -
1. Non-tax deductable, higher interest
2. Lower interest
3. tax deductable higher interest
4. tax deductable lower interest
The exception to the above is when you are drowning in interest payments and are in genuine danger of defaulting - in that case you need to temporarily disregard tax deductability issues and concentrate on getting rid of the high interest debt.
Step 3
Options for Reducing the Interest Bill -
a) Go and talk to your bank or to a mortgage broker about consolidating your debts into one single debt at a lower interest rate. Often, you will find you have additional equity in your home if you have kept up with payments. For example - often car loans can be 10%+ - if you pay out your car loan and add the amount into your home loan at 6% you are immediately saving 5% a year. On a $20,000 car you are saving $1000 per year just by doing this!
b) Talk to a mortgage broker to see if there are better options than the current debt providers you are offering. However pay close attention to the following -
1. Often there will be a "honeymoon rate" for 1 year - this is basically a cheaper rate to entice you to move to that particular bank. This could be very helpful to get you through your current tight period. However be careful to also look at the long term rate (Comparison Rate) to make sure you don't get a nasty surprise in 12 months time
2. Compare the break fees charged by your current bank with the interest savings. Often there will be a large early-payout fee you must pay to switch banks - make sure this doesnt wipe out all your savings
Step 4
General Tips -
- NEVER take out a loan or buy on credit an asset which is not used to generate any income. Examples of this would be - taking out a loan to pay for a holiday, buying something on your credit card which you cannot afford to immediately pay off before interest starts accruing. If you don't have the money you can't afford it. This category does not include a motor vehicle - you will need one of these to get to work no doubt.
- While we are on the subject of cars, let me make this point clear - motor vehicles are the biggest wealth destroyer for the average household. What other asset would you spend, say, $40,000 and then in 3 years it will be worth $20,000? That is costing you $7000 a year!!! Add to this the cost of insurance, fuel, repairs etc and it takes a large chunk of your free income
- Therefore, consider whether you even need a car - can you take public transport to work?
- ALWAYS pay off your credit card when it is due, in full, to avoid paying the high interest rates of credit cards. If you cannot pay off your credit card each month, you are spending too much!
- If you have a margin loan, consider pre-paying the interest just before the end of the financial year - you will get a tax refund soon after which will give you additional cash flow.
- Consider selling any unused assets on Ebay - you will be surprised what people are interested in buying
- Cut out unneccessary expenses while you are in your 'financial recovery' phase - such as -
- Cut down on cell phone/mobile phone usage
- instead of buying books, go to the library
- cut out impulse purchases
- View your 'recovery phase' just like a company would - set yourself financial goals and realistic means to achieve them
- A good way to reward yourself is to buy something nice with some of the money you save in interest payments - that way you have a tangible way of experiencing the benefits
