How to Understand Personal Debt better – Now get rid of it?
Debt, the Biggest Wealth Trap.
When you’re personal spend exceeds your personal income, this shortfall is a result of overspending. It is not possible to spend more than you have, borrowing is one way to cover the shortfall. This negative state of your financial affairs is the result of borrowing money from a second party, family, friends, bank and financial lending institutions.
The agreement is to pay this money back over a time period with or without an interest rate clause. Debt is therefore a state of financial position where you owe money to someone or an institution.
Debt linked to the banks interest rate, is interest debt, the interest rate is the cost of debt for the borrower, and examples are home equity loans and credit card debt.
The interest rate fluctuates according to the federal funds rate, this is the rate at which banks lend to other banks.
Currently, Consumer debt is on the increase globally due to the pandemic which is cause for concern.
In a recent report, released by the Bureau of Economic Analysis, Personal income decreased 2.7 percent while consumer spending increased 1.0 percent in August 2020, according to its estimates. This is yet another concern.
Do you get that sinking feeling that you’re stuck in debt mode, whatever you try you just cannot escape it. You never have enough buck to get you through the month. You can’t afford a Holiday! You keep paying but the debt never goes away. Does this sound like you?
Have you taken time to really understand why you in the position you’re in?
Let’s first better understand debt and how deep you’re in, then create a strategy to get out and stay out.
“A man in debt is so far a slave.”
Ralph Waldo Emerson
What is Good Debt
When you’re borrowing money to acquire an asset or assets that grow in value over time.
What is Bad Debt
Things we buy for immediate consumption using borrowed money. Avoid emotional spending for immediate gratification at all cost
Types of Debt
Debt can be in two forms, either secured or unsecured.
Secured debt – a loan granted against an asset, usually a house or vehicle, used as collateral against the loan. Simply put, if the borrower does not honor his/her monthly payments over time, the lender can seize the asset and sell it to recoup their money. The interest rate on this type of debt depends largely on the credit score/rating of an individual, the more creditworthy a person is deemed to be the lower the interest charged.
Unsecured debt, such as credit cards and personal loans, there is no asset to act as collateral. If the borrower defaults, the credit providers have to take them to court to recoup their money. This type of debt usually comes with a higher interest rate to mitigate the risk of the loan.
In general, having an excess of unsecured debt is less favorable, when applying for credit
Three types of common debts most people incur.
Short Term Debt – is viewed as a bad debt expense, and includes credit cards, store cards, personal loans and hire purchase agreements. They vary from 12 months to 2 years.
Medium Term Debt – is also bad debt, these are purchases over a 3 to 7 year period, like motor vehicle or boat debt. The vehicle loses value over the payment period and is worth a lot less than the actual purchase price.
Long-term Debt – usually 10 to 20 years is good debt because the borrowed money is used to purchase an asset that will retain or increase in value over time like a house, land, or commercial building.
mKnow your Debt profile
Understanding and unpacking your debt profile will prepare you to manage and pay off your debt.
When you have multiple debts, it may be best to consolidate debts, with a debt consolidation loan, where you only make one monthly payment to a single borrowing institution.
Debt settlement companies also offer assistance to manage this part of your debt through negotiation with credit companies, usually, they charge you a monthly fee for their service.
This will present a more favorable position for future credit providers.
Understanding Basic Personal Finance Terminology
Accounts Receivable – All income earned from rentals, Interest paid on personal loans, dividends, and interest paid from investments (stocks and bonds), and your monthly salary.
Accounts Payable – Credit cards, personal loans, interest on loans, hire purchase items, motor vehicle, house expenses, rental, school fees, medical aid, insurance, etc.
Bad Debts – money owed, usually to credit companies, the borrower defaults and is unable to make the necessary payments as agreed.
What is the debt to income ratio? – knowing yours is a must.
The best way to assess your ability to pay current and future debt is to work out your debt to income ratio. This is all monthly debt commitments over your income, your salary and other monthly income streams expressed as a percentage.
To calculate your debt-to-income ratio, add up all your monthly payment commitments – life insurance, medical aid, school fees, rent, car repayments, etc. Exclude -discretionary expenses like groceries and entertainment from this calculation. Divide this by your net monthly salary to get your debt-to-income ratio.
Debt to income ratio ranges:
• 0 to 20% – Low risk, good
• 21 to 40% – Medium risk, fair
• 41 to 60% – High risk, poor
• 60%+ – Very High risk – overextended (considered Bad, relative to your income bracket)
What is the debt to asset ratio? – manage your future by knowing.
When deciding to borrow money to buy an asset, credit providers will assess your debt to asset ratio for these larger credit extensions. These include home loans and vehicle finance.
Calculate your debt to asset ratio by dividing your total debt by your total assets.
This calculates how much of your assets you will have to sell to cover the cost of your debt.
The correct method is more complex and will include some of the below or additional factors
- the type of debt
- loan period (5,10,20)years
- the life stage of the individual
- Asset appreciation/depreciation
When your personal debt is more than your personal assets, you are a risk to creditors and a deeper assessment is required before approving a loan.
“Wealth is the ability to fully experience life.”
Henry David Thoreau
Strategically pay off your debt
A general recommended strategy, pay-off the debt that costs the highest interest rate. When you have additional funds available, pay off your debt sooner.
These are your unsecured debts that draw interest, credit cards, store cards, and personal loans to name a few.
There is no one fits all strategy. Assess your personal debt portfolio then create a strategic plan where the main objective is to reduce debt to zero and start wealth building.
Create yours now! Then follow through with action.
Some ideas using your talents to generate additional income to pay your debt faster.
• Get a second Job.
• Start a side hustle – business