Session 4 Managing your debt
INTELLIGENT BORROWING OR STUPID DEBT
Mary Hunt in her book “debt-proof living: The complete guide to living financially free”, compares “intelligent borrowing to stupid debt”. The only thing worse than investing in things that depreciate is paying interest on money invested in things that depreciate…. Blain Harris.
Let’s compare a home loan with a revolving credit card balance. Both are liabilities for which the borrower is legally responsible. The first she calls intelligent borrowing, the latter – stupid debt.
Intelligent borrowing means that some level of safety and limited risk for both the lender and the borrower is built into the transaction. Here is what intelligent borrowing looks like:
1. The borrower has a safety valve — a legally and morally sound alternative to get out of the obligation.
2. The debt is secured. The lender holds something that is at least as valuable as the amount of the loan, something known as collateral. Think of collateral as a security deposit for the lender.
3. The loan is for something that has a reasonable life expectancy of more than three years as opposed to something that will be down the drain before the bill arrives.
4. The loan is for something that will increase in value, unlike a couple of movie tickets and dinner in a fancy restaurant, or a great new outfit.
5. The interest rate is reasonable.
The best example of intelligent borrowing is a home loan. Let’s see how it measures up to each of the intelligent borrowing characteristics:
1. Is there a safety valve or escape route? Yes, if you find you just can’t handle those high payments or you want out for any other reason at all, you can sell the house and pay the lender from the proceeds of the sale.
2. Is the debt collateralized? Yes. With a mortgage, the property is the collateral — the lender’s security.
3. Does the purchase have a reasonable life expectancy of more than three years? Yes, of course. This is true not only for the structure itself but also for the land on which it sits. Buying a home is a long-term investment.
4. Will it increase in value over time? Yes. Property is normally considered an appreciating asset even though specific values may decline during economic cycles. As a general rule, property always gains in value over time.
5. Is the interest rate relatively reasonable? Yes. In nearly all situations, home loan rates are lower than other types of consumer loans.
Sometimes borrowing starts out intelligently and then turns stupid. For example:
1. If you borrow against your home loan (e.g. access bond) to clean up your credit card debt and then run up your credit cards all over again, that leaves you with twice the debt—the home loan and the credit cards. Not smart.
2. The convenience of having your access bond available at your fingertips can be a formidable temptation. Knowing the money is readily available, you are more likely to spend it on something, like a well-deserved family vacation, instead of saving the money first as you might have if you did not have such easy access to borrow.
Can arise from
1 Unforeseen circumstances (Emergencies, illnesses family problems)
2 Unwise expenditure due to greed, social pressure etc. (Stupid debt)
In both instances it is important to note that as we serve a loving God, he does not wish for us to remain in a lengthy detention class to “learn a lesson” but He is faithful and just to provide fro us and to walk with us as we make our way out of trying circumstances.
This is the kind of debt you agree to, often impulsively. Credit cards are by far the most popular. Almost anyone these days can get a credit card. Someone with a credit card and available credit limit can in effect take out very expensive loans on a whim and at nearly every place.
Let’s say you use your credit card to acquire the very latest computer, and—the best part—a free printer. It’s on sale and you want it right now. Why should your lack of cash prevent you from making this really good deal? You have plenty of room on your account to cover it. The last thing on your mind is how you will actually pay for it. You didn’t consider for one second how this new debt will affect your current payment structure. It can’t be that bad, you reason, because you got it approved. And you get a free printer!
Let’s see how this purchase measures up against the criteria for intelligent borrowing:
1. Does the borrower have a way out at any time? No. If you don’t pay as agreed, the credit card company won’t come after the computer—they’ll come after you. Unless you can sell the computer for what you paid for it, you have no way out.
2. Is the debt collateralized? No. The credit card company is holding nothing of value to fulfill this debt if you are unable to pay. But they’ve got a tight grip on you. They don’t want that computer or anything else you buy with a credit card, for that matter. This loan is unsecured.
3. Does this purchase have a life expectancy of at least three years? No matter how you cut it, a three-year-old computer is not exactly cutting-edge technology.
4. Will it appreciate in value? From the minute you walk out of the store, a computer is in the fast lane to obsolescence. It’s depreciating with every click of the mouse.
- Is the interest rate reasonable? No. The average credit card annual interest rate is between 19% and 23% percent.
The computer purchase fails the intelligent borrowing test miserably by getting a “no” response to all five questions. Paying for a computer over time cannot qualify as intelligent borrowing, and if paid for with a credit card or other form of consumer credit, it would qualify as a stupid debt.
While the computer example is remarkably illogical, other kinds of stupid debt make the computer scenario appear somewhat reasonable. Turning restaurant meals, travel, groceries, utility bills, movie tickets, vacations, gifts, petrol and school clothes into debt and then choosing to pay for them with minimum monthly payments over many years and at rates that effectively double the original costs brings new meaning to the term stupid.
Spending money you don’t have yet to pay for things you don’t have anymore is anything but intelligent. Nevertheless, that is exactly what millions of people in the country are doing every day, every month, year after year after year.
QUESTIONS TO ASK YOURSELF BEFORE APPLYING FOR CREDIT.
- Ask yourself, is the loan really necessary? i.e. Do I need this? Do I need this now? Often a better approach is to save for the expense. Then you avoid paying any interest payments. Many people take loans because they are undisciplined and greedy; they want to have more and they can’t wait. Beware of this. Make sure you have a genuine need for the loan.
- Pray for wisdom and guidance. Whatever money you have is God’s gift, and you don’t want to waste it on unnecessary interest payments. Ask God to help you be wise in how you use the money he has given you.
- Have a sound financial plan for repaying the loan in the specified time. Don’t just think that somehow you will find the money when repayment time comes. Repayments must be part of your budget so the money is put aside and you don’t default on the loan. Do not proceed until you have a plan which is achievable. Ask questions like
How much more will I pay if I buy on credit?
Can I afford the monthly payments?
What is the total cost of credit?
What is the annual percentage rate?
4. Seek professional financial advice from someone other than the money-lender. Show a financial adviser your plan and get an independent expert opinion on whether the loan is necessary and whether the repayment plan is realistic.
5. Is there an alternative to borrowing the money? Could you rather save for the item you need? Could you generate income from another source? Could you sell something to raise the cash?
APPLYING FOR A LOAN
Creditors look at your ability to repay debt and willingness to do so. In some cases they may also look for a little extra security to protect their loans.
Creditors also speak of the three Cs: Capacity, Character and Collateral.
Capacity. Can you repay the debt? Creditors ask for employment information: your occupation, how long you’ve been with your current employer and how much you earn. They also want to know about your expenses: how many dependents you have, whether you pay alimony or child support, and the amount of your other obligations.
Character. Will you repay the debt? Creditors will look at your credit history: how much you owe, how often you borrow, whether you pay your bills on time, and whether you live within your means. They also look for signs of stability: how long you’ve lived at your present address, whether you own or rent your home, and how long you have been in your present employment.
Collateral. In some instances creditors also look for protection or collateral to cover their risk. In these instances they would want to know: are they fully protected if you fail to repay them? They also want to know what you assets you have that could be used to back up or secure your loan and other resources you have for repaying debt other than income, such as savings, investments or property.
Creditors use different combinations of this information to reach their decisions. Different creditors may reach different conclusions based on the same information. One may find you an acceptable risk; another may not grant you a loan.
HOW TO MANAGE YOUR CREDIT RESPONSIBLY
- Manage your money responsibly. Get into the habit of paying on time, and ensuring that all your accounts are paid in full every month. If you have a bad credit record, you will usually be charged a higher interest rate.
- Pay more than the minimum repayment requested in order to reduce the outstanding balance.
- When making a large purchase such as a car or a house, put down the largest deposit you can afford. Its lowers the outstanding balance from the outset, and reduces the interest you will be liable for.
- Be realistic when you apply for credit to buy something, and don’t overextend yourself. Make sure that you will be able to repay the loan and the interest. Markets are volatile and interest rates fluctuate. If you are stretched to your limit with a low interest rate, you will be in trouble should the rates start rising.
- If you do get into serious debt, speak to your bank as soon as possible. Structure an affordable repayment plan with their guidance, and be disciplined about sticking to it. Don’t use debt consolidators/administrators. They will charge you far more interest and make your problem worse.
- If you receive a judgment against you, it will remain on your record with the credit bureau for five years, during which time no credit grantor will lend you money. You will always be considered a high risk, which means you will always be charged the highest interest rate.
- Know the difference between effective and nominal interest rates. Normally, banks will quote you a nominal interest rate when lending you money, but a higher, effective interest rate when you invest money. The nominal interest rate is the simple rate. The effective rate is calculated by compounding the interest earned or charged.
- Never use debt on which you have to pay interest to buy products you consume. You are in effect making the items far more expensive, and will be able to save less and buy less in the long term.
- One of the best investments you can make is to repay debt. Interest rates inSouth Africa are high. By paying off debt, you get one of the best returns available, tax-free.
- Always negotiate your interest rates. Shop around. A one-percent difference can have a significant effect. On a R100 000 mortgage bond over 20 years at 12 percent, you will repay R164 261 in interest. At 11 percent, you will repay R147 725 in interest a saving of R 16 536.
- When mortgage bond interest rates come down, keep your repayments at the same level. You will pay off your bond quicker and save yourself a whack in interest repayments. Repayments will also not be so difficult to contend with if interest rates rise again.
- Most mortgage bonds enable you to repay more than your set repayments. This is useful to use as a savings account. The effective interest you receive is much greater and there are no additional costs. Say, for instance, you need to put away money to pay school fees or provisional tax. “Save” the money in your mortgage bond until you need it, rather than in a low-interest bank savings account.
Get a pre-approval agreement on a mortgage bond before you start looking for a home. This will give you the advantage of being able to shop around for the best rate while you’re not under pressure and the buyer will be more willing to sell to you knowing that the money is available.