Managing your debts

By Your Mortgage

If you feel your debts are escalating faster than your income, read on as Your Mortgage magazine examines ways you can reduce the money you owe.

Before you can attack your debts, you need to accept you have a problem – and that it won’t go away unless you work at it. Getting yourself into debt is easy; getting yourself out of debt is much harder, but not impossible.

A debt is borrowed money that has to be repaid. This includes credit cards, personal loans, mortgages, money borrowed from your friends or relatives and any other money you have to give back in the future. In most cases, if you are able to stay ahead of the required repayments debt is not necessarily a problem. It is only when you lose control and the debts start mounting up that it becomes a an issue.

Good debt and bad debt 
Staying out of debt is not a realistic option for most people. You need to be in debt, otherwise you cannot afford to buy a home or a car. The trick is being able to identify what is ‘good debt’ and what is ‘bad debt’.

Good debt allows you to buy assets – items that will appreciate in value over time or that provide you with an income stream. Bad debt only buys depreciating items – consumer goods that fall dramatically in value as soon as you buy them. There is nothing wrong with consumer goods – but you need to have the income to afford to pay for them on the spot, or to pay them off at a faster rate than they depreciate.

Everyone needs a financial plan 
While it is all well and good to say you need a financial plan to manage your money, the truth is that most people do not have one. On those rare occasions where there is a financial plan in place, it is usually woefully inadequate – little more than making sure the credit card minimum repayments are made before the ‘interest-free’ period runs out.

There is no such thing as ‘interest free’ – it is merely a powerful marketing tool aimed at getting you to live beyond your means by thinking you can afford to buy now but pay later. The trap is that you still have to pay, and you will have new debts later because you will see other consumer goods you want/need/ cannot live without. All you are doing is mounting up debts. If you cannot afford it now, how will be able to afford it later?

Lenders make money from people who like using credit. By giving you access to their money, they are making more money for themselves. They are not in business as a public service. They charge you for letting you use their money – joining fees, access fees, interest fees, application fees – the operative word being “fees”. Anything you have to pay out to lenders is money that you and your family have lost and will never see again.

So when it comes to debt, play it smart and make sure you are using your credit for ‘good debt’ purposes.

With your debts mounting, you need options, not advice about how good a financial plan would have been. Right? Wrong! Not thinking got you into this state in the first place, and only thinking will get you out. You still need a financial plan now more than ever.

Traps to avoid

1. Consolidation
Consolidation is often paraded as if it is some ‘cure-all’ for crippling debts. It is not. What consolidation does is combine all your various debts into a single loan with an affordable repayment. So what is the catch? Reducing repayments usually involves taking out the debt for a longer period.

So all you are really doing is piling debt upon debt for a longer repayment term. Sure, the repayment amount is lower, but your repayment period has grown a lot longer and you may now need to provide security for the larger consolidated loan as well.

One solution is to work out an affordable budget and concentrate on eliminating your smallest debt first. Once that is paid off, take that repayment and add it to the repayment of your ‘new’ smallest debt and start paying it off. It may be a slow solution, but you will eventually clear all your debts.

2. Interest-free period
Most retailers of consumer goods offer ‘interest-free’ deals. You are told that the loan contract is for 36 months ‘interest free’ and a statement will be sent to you every month. The statement includes an “amount due” and happily you pay that amount, firm in the belief that in 36 months, the loan will be fully repaid, without one cent in interest. What a sweet deal, right?

The minimum amount you have paid during the interest-free period is only a small percentage of the balance – usually about 3% of the total. By paying just the minimum, you will never clear the debt by the end of the interest-free period and then you will be charged interest.

The solution is simple maths. Ignore the minimum payment amount and divide the total cost by the number of months in the interest-free term. This much larger amount is what you need to pay each month to avoid being charged interest.

3. Temptations
Many people like to shop together as couples or as families. Naturally, as you shop you see consumer goods that look just too good to refuse. The retailer is only too happy to allow you purchase on ‘interest-free terms’ on a credit card. Luckily for you, the lender phones to tell you though you applied for $5,000, you have been approved for a $15,000 limit – eliminating the need to apply again in case you need more money.

Be warned! You have only been approved for $5,000 ‘interest free’. The balance will be treated as a standard loan with a very high interest rate tacked on. Consumers often mistakenly believe that the whole of the approved limit is interest-free for the agreed period. Unfortunately, only the portion used to buy the actual goods is interest fee – and there are account-keeping fees too.

You should also be careful, under some agreements, if the entire debt has not been cleared by the end of the interest free period. Interest can be backdated and calculated from the day of the purchase.

If you really believe you cannot live without interest-free purchases, the only thing you can do is to ensure you fully understand all the terms and conditions attached to the agreement. And you need to make sure that you have the disposable income and the willpower to clear the entire debt over the interest-free period.

4. Mortgage refinancing
A homeowner’s equity is the value of the property less the balance on the outstanding home loan. Lenders have long been keen to entice borrowers to use the equity they have built up in their homes to pay off their credit cards. At first this tactic seems to be a winner. Surely it is better to pay of a loan at 7% than a credit card at 15% or even 20%?

The trap is that it only makes sense if you can repay the combined debt faster than the original debt. For example, if you have a personal loan of $10,000 for three years at 14% and a $150,000 mortgage at 7% with 20 years to run, you can add the $10,000 to the mortgage and pay it of as such.

This is not a good idea. If you absorb the $10,000 into a 20-year-old mortgage and pay it off in 20 years, that $10,000 just cost you $6,300 more in interest payments than if you had stuck by the terms of your original loan! See the table below.

Loan amount Interest rate Loan term Total interest paid
$10,000 14% 3 years $2,310
$150,000 7% 20 years $129,424
$160,000 (combined) 7% 20 years $138,052

Unless you are certain you can repay the refinanced mortgage faster than your separate debts, it may be in your interests not to refinance.

5. Open-ended and fixed-term credit
Fixed term loans are usually small, with a fixed repayment schedule requiring the loan to be repaid in full within a fixed time period. They is an obvious advantage to the borrower, as they know with certainty that if the keep up the repayments, at the end they will be debt free.

Unfortunately, small loans are expensive and the setup costs can be more than the actual interest to be repaid. It is far more profitable for lenders to offer open-ended loans or ‘revolving credit’, which allows borrower to keep the loans indefinitely – as well as being encouraged to spend more.

Revolving credit, such as credit cards, can go on forever, especially if only minimum payments are made. A fixed-term loan has finite size and finite life, and is a better option for borrowers who either cannot be trusted with a credit card or have difficulty keeping track of their finances.

6. Small repayments
Lenders can make anything seem affordable if they divide into small enough units. A $3,000 air conditioner seems affordable at only $5 a day, but if you read the fine print, the loan period can be for several years – requiring you to repay many thousands more than it would have cost you to buy it outright.

One precaution you can take against these alluring offers is to sit down and calculate the actual cost before signing on the dotted line. You will be glad you did.

7. Multiple credit cards
Credit cards debt is often ‘bad debt’, and needs to be eliminated at the first opportunity. Keeping your credit card balance high is always risky as there is often no asset-backing for the debt. Make sure you pay them off as quickly as possible.

Credit cards are a great way to waste your money on unnecessary goods and services, but with interest rates hovering around the 20% mark they are a risky and expensive at the best of times.

8. Focusing on one aspect of the loan
Just as consolidation debts are sold on the promise of ‘lower repayments’, lenders promote their other loans by highlighting particular aspects about them. Remember, the key criteria for any loan are amount, term, rate and fees as these determine your interest and total repayments.

Try to only borrow to build your asset base. If you have to borrow to buy a consumer good, try and pay it off before the end of its useful life.

Taking control of your debt
The best way to avoid bad debts is to have a sound financial plan and not to let yourself be tempted away from your long-term strategies to accumulate wealth. You need to think about your options: Do you really want to spend $30,000 on a-round-the-world trip, or is it better to spend a week at Fiji and use the balance as part of your deposit on a home?

Now that you know about the most common debt traps, it is time to stop talking and for you to take control of your debts. It is better to start off small and refine it later, otherwise you will have too much to do and, like a diet, you aren’t likely to keep at it for long. The best way to break a bad habit is to replace it with a good habit.

You have heard of 12-step programs – well, here is a five-step program to better finances:

1. Track your spending
How many times have you been caught short because you thought you had more money than you actually did? You know you worked and got paid, but you do not know where you spent it all. The first step, then, is to start tracking your money for a month or two.

This step is really easy. Every time you spend money, write it down. $2.50 for a can of coke? $15 for a lottery ticket? $5 for a meat pie? 50 cents for a stamp? Write it all down!

This may not be very exciting, but you will get a shock when you do it. You will not be able to believe how much you spent on low-value consumer goods like take-away food and cigarettes. Think about how much coffee you drink and how many muffins you eat. At $5 a day, that is $25 a week or $100 a month – on coffee and muffins! Don’t forget lunch, juices, lollies, drinks with friends – it never ends.

You do not notice how much money you waste because you do not think about it. Get into the habit of writing your expenses down and you will start thinking about your spending habits. Pretty soon you will start being more careful with your money by spending it on things that are worthwhile to you.

2. Develop a debt-attack plan
Have you heard of the military strategy of ‘divide and conquer’? You can do the same thing to your debts. It took effort on your behalf you build up big debts, so it is going to take effort by you to reduce those debts. You can think of cutting debts like a person trying to lose weight. You are not going to achieve anything unless you embrace a lifestyle change and a sensible diet – in this case, a debt-attack plan.

The first thing you will notice is that you cannot afford to pay off all your debts at once. So start of with the smallest one, and when that is paid off add that repayment to the repayment for the new smallest debt you have. It is amazing how much debt you can clear with a decent repayment system.

3. Debt consolidation 
Although debt consolidation can end costing you dearly if you let the loan run too long, it can be an excellent way of focusing your debt control in one direction. Bad debt loans such as credit cards can be effectively targeted and reduced by this method, but only if you are prepared to make bigger repayments than just the minimum. Remember, time and loan size are your enemy here.

4. Roll over debts 
Interest rates can be crippling on credit cards, so it is worth thinking about rolling these debts to a credit card with lower interest rates attached. Many lenders are happy to offer low introductory rates for six to 12 months on their cards to attract your business. Take advantage of such offers or shop around for a competitive rate and set yourself a realistic time frame to pay off the cards.

5. The dreaded budget
Do not fool yourself that you do not need a budget. If you spend money, you need a budget. Remember, convenience costs money. Every time you get something pre-made it is going to be more expensive than if you did it at home. Take a simple lunch: two ham and tomato sandwiches, a can of drink and a few pieces of fruit. That will usually set you back the best part of $10 if you bought it from a shop. If you brought it from home, it would cost less than $2! The same goes for processed dinners and snacks.

The best start you can make to a budget is to skim about 15% off the top of your wages to repay your debts. Depending on the size of your debts, you may have to go even higher. With mortgage repayments claiming up to 30% of household income, finding additional money to pay off debts is going to be very hard. But putting yourself on a budget and tracking your expenses means that you will be inconvenienced for as short a period of time as possible.

Taking responsibility for your debts is the only way you will overcome the problem. It will be hard, and it will take time, but at the end of it you will armed with enough tools to ensure you never become a credit victim again. Having a financial plan does not mean you have to miss out on the good things in life altogether. It just means you have to budget and think about how you are going to get them. There is no reason why you cannot enjoy holidays, treats and nice things – just think about how you are going to do it. Then do it!