Debt Management 101
Debt! Many people don't want it, but a lot of us can’t achieve our goals and aspirations without it. Debt in and of itself is not a problem. In fact when used correctly, debt can be a tool for wealth accumulation over the longer term. People purchase fixed assets, like land or a home, with the expectation that the asset will become unencumbered after the debt is repaid, and then that asset can be leased or sold at a higher price for a profit. Alternatively, a person can use debt to achieve a long term aspiration much sooner, but in a structured way to ensure it is safely funded.
When issues arise surrounding debt, they are often related to how debt is managed. Before assuming a new debt, you should ask yourself the following questions: How much is too much? What can I afford to repay? How do I use debt effectively? It is important that you take the right steps to ensure that debt helps you to achieve prosperity and reach a long term goal sooner as opposed to something much worse.
How much debt is too much debt?
To answer this question you must know what is affordable to you. Of course, the answer is linked to your level of income. For example while $100,000.00 in debt may be significant to one person, the same amount may not be at all substantial to another person. The difference stems from how much one person can afford to commit to service the debt versus another. While income is an important component in the affordability test, expenditure has to be equally taken into account. The difference between income and expenditure is referred to as “disposable income” and is the starting point of the affordability test. Various formulas exist which help to determine a yardstick for what is affordable, and a common one is called the Total Debt Service Ratio. Simply put, it is a ratio calculating what percent of income is used to meet all debt costs. Generally speaking, a TDSR over 40% has the potential to lead to financial difficulties.
“Before assuming a new debt, you should ask yourself the following questions: How much is too much? What can I afford to repay? How do I use debt effectively?”
How can you manage debt?
Debt is often made up of many components. For instance, some people have a mortgage for their home, a car loan, a credit card, education or student loans, and maybe a hire purchase agreement for furniture. These various pieces of debt often carry different terms and rates. Mortgage debt tends to be the largest single debt that most people have. In addition, it usually has the longest term (between 20 and 30 years) and the lowest rate among the debt categories. At the other end of the spectrum, credit cards and hire purchase agreements have much shorter terms and traditionally much higher rates. These higher interest rates are related to the fact that the debts are unsecured, and therefore they have higher risk. Secured debts, such as property in a mortgage, have much lower risk and consequently lower interest rates. Below you will find some suggestions for how to manage your debt effectively:
A good strategy is to keep the debts at low rates as much as possible, and one way to achieve this is to switch from high interest rate debt to low interest rate loans. This is often possible by refinancing higher interest rate debt, like credit cards and hire purchase agreements, with lower interest rate loans.
Consolidating multiple debts into one single debt is also a good debt management tool, especially if some of the debt is revolving, like a credit card. By consolidating multiple debts, the interest rate and monthly payments are likely to be reduced, which improves your TDSR and your overall cash position. By refinancing revolving debt (like credit cards) into a reducing loan means it will eventually be repaid.
Another way to manage debt is to reduce the balance owed faster than is required or originally arranged. This may seem impossible if you are already on a fixed income or operating on a tight budget. However, it is possible with a little determination! Here are three basic approaches: 1. Cut back on expenses (e.g. cut out non-essential purchases), 2. Increase your income (e.g. get a part-time or weekend job) or 3. Sell items you don't need (e.g. have a yard sale for items you no longer use). By saving on non-essential purchases each month, you may be able to pay a little bit extra along with your regular payment, or the money from your yard sale can be used to apply a lump sum. These additional payments can cause the debt to reduce at a much faster rate. In other cases, extra cash received by way of a bonus or a matured insurance policy can be used to reduce the principal, which also leads to a reduction of the overall debt.
One more way of managing debt is to not increase it beyond what is manageable. This can be achieved by planning for your financial future and creating a budget to help you reach those goals. A budget helps you to make wise decisions about your present spending and saving and to determine what disposable income you can allocate to new debts so as to not jeopardize your future financial well-being.
Debt need not be a problem, and when used correctly, it can lead to wealth creation and help you to achieve your long term goals, often sooner than expected. The above steps are just a few of the ways in which debt can be managed effectively to achieve your financial objectives.