Discover where your money goes > Get rid of toxic debt
03 September 2019
The topic is debt and the impact thereof on your financial planning – that was the easy part, words on paper. However, what is normally our first reaction when we are faced with this toxic issue in real life? Denial. This is clearly not only a river in Africa, but also one of our most basic instincts when facing the demons of debt!
Money can’t buy happiness, but it pays the bills
"Money can't buy happiness". We have all heard this saying before. However, I do not think the person creating this saying has ever stared at his or her monthly accounts and a "zero bank balance" at the same time. Therefore, money cannot buy luck, but it pays the bills!
This is one way to look at it. As an alternative, consider:
- Reducing your expenses
- Reducing your debt
You will have the same amount of cash flow available, but fewer expenses and less debt. Therefore, more of your income will be available to achieve your financial planning goals.
Debt reduces your financial abilities and may ultimately lead to bankruptcy. This is not ideal; we all want to live a debt-free life.
Debt can be divided in two main categories i.e. toxic debt and “healthy” debt:
- “Toxic debt” is that “overdraft”, the credit card or the personal loan that funded last year’s holiday
- “Healthy debt” is buying a house or financing your car
Therefore, not all debt is “toxic debt”. Not everybody is in a financial position to buy a house with cash! Keeping your credit score healthy is critical for future credit applications. Lenders use past credit applications and credit reports to evaluate your borrowing history using algorithms. Your credit score will influence their decision when it comes to offering you an interest rate, term and amount.
Do your best preventing debt collectors becoming part of your credit score history. How do you do this? You need to arrange some form of payback schedule with your lenders/creditors and keep to that arrangement. Also, remember to keep engaging with your creditors on an ongoing basis.
Good to know, however, is that debt collectors cannot gain access to your retirement funds.
What is the effect of toxic debt?
Debt is toxic because in its worst form it is a type of mental illness. The feeling it causes is enough to drive anyone insane. A disease that will stick around until it is tackled. There is no guarantee that debt will not become an issue in your financial planning sometime or another, because we are all susceptible to this disease.
We have previously referred to “healthy” debt and a good example of this is when you buy a house. Have you ever calculated how much interest you will pay over a 20-year mortgage period on this “healthy debt”?
- A mortgage of R2 000 000,
- An interest rate of for instance 10.6%,
- The interest of R2 824 509 will be paid over that 20-year period
The total interest you pay back to the bank is more than the initial capital borrowed. Even good debt can feel rather toxic at times!
On a practical note, the portion of your revenue that you use to settle debt represents income that is not available for any day-to-day expenses and your other personal financial goals. Part of your financial planning should be to achieve financial goals, whether it is short or long-term. This is the real cost of debt – what are you forfeiting towards achieving your goals because of your debt obligations.
The next tier is creditors and their ability to access your net worth. Being in debt makes one wonder what assets are protected from the circling creditors. As mentioned before, your retirement funds will be ring-fenced until retirement. Other investments like unit trusts or cash in the bank account is open season when the gunfight at the O.K. Coral starts. Some assets are protected and others not, depending on the nature and structure of the asset or investment.
The interaction between debt and financial planning goals
Personal financial planning is an ongoing process and during this lifelong journey, there will be financial goals along the road, whether it be short, medium or long-term. It is, however, a misconception to associate these financial goals only with investments and savings:
- The reduction and elimination of debt should definitely be part of your short-term financial planning goals
- If you can achieve this, additional income will be available to fund other financial goals, whether it is that short, medium or long-term investment and saving goals
- No one wants to be in a position where his or her retirement funds settles the debt at retirement
On death, you may have a spouse and/or children who are financially dependent on you and as part of your financial planning; you should have made provision for that. These funds or insurance proceeds must not be used for liquidity purposes or to settle debt when winding up your estate.
What you should not do about your current debt situation
Denial - the only effect denial will have is a downward spiral into the world of stress, fear, anger, and depression. There is a popular Chinese proverb: “The best time to plant a tree was 20 years ago. The second best time is now.” Therefore, if you want to achieve success and growth in the future, the best time to take action is now.
Albert Einstein best summarizes the interaction between interest paid and interest earned as follows: “Compound interest is the eighth wonder of the world. He, who understands it, earns it. He, who does not, pays it. ” Debt enriches other people and institutions, meaning you are making other people and shareholders rich instead of yourself!
Choose financial empowerment as an integral part of your personal financial planning. Also:
- Do not pay debt with debt
- Keep in mind that your creditors may have an impact on your future credit rating
How to get rid of debt – pay off your debt as fast as possible?
Start prioritizing: need versus want.
First pay off that debt with the highest interest rate. Usually it will be credit cards, short-term and personal loans. Do not use your credit card to pay off other debts. Do not create more debt to settle your current debt; it will only worsen your financial situation. Getting rid of debt will take financial discipline, a plan and time. Be committed and get rid of those unnecessary credit cards!
“CREATING A BUDGET”
A budget will allow you to map out the in- and outflows on your income statement. A trusted financial advisor who looks at your finances independently can assist you in making your budget healthier so to speak. As part of getting rid of debt, you may consider consolidating your debt. However, be aware that you may potentially expand your repayment term and end up paying more interest over time. The upside of this may however be that the consolidation of debt reduces your monthly repayments and improve your disposable income. When that happens, do not take up more debt! Use the excess funds towards other financial goals.
Debt counseling may also be considered and it could prevent you from having a bad credit score. It could involve legal processes and procedures where a debt counselor will be part of the process. This involves the restructuring of the repayment process by means of a court order. However, you must make a well-informed decision before you go this route.
If you stick to your plan and stay disciplined when you consolidate your debt and do not take on more debt, you will become debt free over time. Do yourself a favor and make getting rid of debt a primary financial goal in your financial planning, whether short-term or on death.
Whilst on the subject of death, your executor must settle “normal” debt like the mortgage as part of the administration of your estate. Whilst the focus is on toxic debt, remember that “healthy” debt like a mortgage can turn toxic in the blink of an eye on death. When there is not enough liquidity in your estate, your executor will sell assets in order to settle debts. Take care!
The following steps are a summary on how to tackle your unique debt situation. Ultimately, discipline, time and sticking to your financial plan will be the path to becoming debt free.
- Take stock of your current financial situation. Plot down your financial life on the proverbial spreadsheet. Look at the cost of credit such as interest rates and fees
- Create a budget listing all your income and expenses
- Identify the biggest expenses and consider where you can cut and trim
- Investigate debt consolidation and debt counseling as a tool to manage the repayment of debt
- Pay more than the minimum payments on debt – the only way to deal with debt is to pay it off quicker. The faster you pay your debt, the better
- Monitor and adjust
In summary – you can choose to receive interest rather than to pay interest. Einstein was right about compound interest being the eighth wonder of the world. You have to be the person earning interest to be on the receiving side of this wonder!
Plant your financial empowerment tree today and start living debt free with no toxic financial liabilities and obligations.
Get your Personal Financial Plan created and managed by an ABSA insurance financial advisor. Send an e-mail to AdviceGurus@absa.co.za or call 011 225 1797 and start your journey of financial planning success.
Disclaimer: The advice contained on this blog is for general purposes only and does not take into account individual circumstances, objectives or financial needs. Accordingly, readers are advised to seek appropriate advice from licensed professionals prior to making any investment, or taking up a financial product or service.