How to make smart decisions about debt
DEBT is a major cause of financial stress. A total of 64% of participants in Old Mutual’s Savings and Investment Monitor indicated that their stress levels are overwhelming because they have too much debt and are struggling to manage it. Before taking out any kind of loan, you should consider whether you can really afford it and whether it’s worth the money and the stress. Be honest with yourself when answering the following questions.
1 CAN I AFFORD IT?
Before buying an expensive item on credit or taking out a loan you need to work out if you’ll be able to make the payments. Calculate this by subtracting all your existing expenses from your income.
Your bank statements are a clear record of your income and expenses. Your starting point should be your income after your employer has subtracted tax and other expenses, such as your pension contribution. Take into account all current expenses – from rent, petrol and grocery money to helping a family member with school fees. Also include emergency expenses, such as medical costs.
The sum is your monthly income minus your monthly expenses = how much you’ll be able to pay off monthly. The answer to this sum should comfortably cover the debt amount.
WHAT IF I SAVE 2 FOR WHAT I WANT INSTEAD?
Some people believe it’s more affordable to buy something on credit because the monthly repayments look like smaller amounts compared to paying a large, once-off amount. This isn’t true. It’s always cheaper to buy cash because you won’t be paying interest.
Andrew Davison of Old Mutual Corporate Consultants gives this example: you’ve decided to buy a lounge suite for R25 000. If you take out a loan over 36 months at an interest rate of 18% you’ll pay just more than R900 a month. You’ll receive the lounge suite immediately but end up paying R32 400 for it over three years. Of this, R7 400 is interest.
But if you’re able to delay gratification and save the R900 every month, you should be able to save up R25 000 in less than three years.
You will also be saving a lot of money because you won’t be paying all that interest.
WILL IT ENHANCE 3 MY LIFE OR WILL IT DEVALUE OVER TIME?
Not all debt is bad. Good debt is something that will add value to your life over time, such as a student loan or when you buy property that appreciates in value – provided you can afford the bond.
Bad debt is anything you can’t afford and that doesn’t appreciate in value over time, such as a car loan. Good debt is only positive if you’re able to pay it off consistently. If you fall behind on payments or you take out a student loan but end up partying your time away and failing every subject, it certainly won’t be to your advantage.
4 WHO IS IT FOR?
Be careful not to take out a loan because a friend or family member wants to use the money. If you fall behind on payments, you’ll be the one who’s branded a bad debtor, not them.
Set and stick to clear boundaries as to what they can expect from you so that you can prevent false expectations and negative attitudes. You can suggest they see a financial adviser who can help them draw up their own financial plan.
Think really carefully before signing surety for someone else’s loan. Experts say many contracts of guarantee contain fine print that’s usually much more detailed than most people realise.
For example, it could mean that if you take a loan and default on even one payment the creditor might legally be able to confiscate some of your assets. And once you’ve signed a contract of guarantee, you can’t change your mind.