Love it or hate it, just understand it before it kills your wealth
At some time in our lives, (usually early on) debt is unavoidable, especially for high ticket items like houses or cars. Depending on how you were brought up, it was either dead easy or as scary as hell. As time goes by we get used to it, so the next debt we take on is easier, and if we’re too complacent or have a run of bad luck then it can spiral out of control. Debt isn’t just a number on your balance sheet, it often has a physical effect on you. Obviously it is going to depend on your risk appetite, but usually, the more debt the more stress you take on. Some people relish in that stress, but they are in the minority.
We are often sent mixed signals about debt, especially if we are in business. ‘Leveraging’ (which is just a fancy word for debt) is seen as ‘smart’. “Use other people’s money” we’re told over and over, so how do we fix our relationship with debt, get it into perspective and understand ‘good’ and ‘bad’ debt?
For a start, if you’re in business and you have limited liability then leveraging your business is often smart and necessary so you can gain critical massJust be aware that banks have cottoned onto this ‘limited liability’ and directors now have to sign personal surety for any ‘accommodation’ (yet another euphemism for debt) you’re given (read the small print). They prefer it if that surety is backed up by a physical asset too of course so if you don’t pony up when they ask, they can just take your house. Lose/lose much?
Being in debt early on in your life is like being on diet, you can’t eat nothing or you will die, so you have to find a happy balance. Of course, everyone’s balance is going to be different, but again, like weight, there is going to be an ‘acceptable’ zone. If you decide to have zero debt ever (and don’t have a trust fund to live off) then you may wait decades to get onto the property ladder. Owning your own home is not a necessity, far from it, but let’s look at when it is sensible, and when not. A mortgage bond is made up of two components, interest and capital. These days even the banks will split this up on your statement. The interest is rent, the capital is your investment. If you rent, then your payment should not exceed the interest portion of a new bond. Why a new bond? As time goes on, capital is built up in the asset and the interest portion comes down until the last few years when it is almost all capital/investment. As a landlord you usually want the tenant to pay off the entire bond, interest and capital, and more often than not that is what happens. A landlord will justify the rest as ‘risk’, with good reason. Regulations are not landlord friendly and defaulting tenants are on the rise. So, basically, if your rent is more than the interest on bond you could get on that property you should get your own. Having your own rental property is a whole different topic, but you can read about it on my blog HERE (or HERE or HERE - it is a pet topic of mine).
When deciding what is good and bad debt there are two things to take into consideration, the interest you’re paying on that debt and what percentage that debt is of your annual income. It is also important to read the small print in that debt agreement and make sure you’re not tied into something for years with no escape clause (without penalties). If you’re unfamiliar with ‘cheap’ or ‘expensive’ debt it’s time to do a bit of research – it will only take minutes but will save you thousands in the long term , thousands that you could be ploughing into your wealth.
The Reserve bank sets the ‘repo rate’, at the moment it is 7%. Prime interest rate is usually 3.5% above this, i.e. 10.5%. That is the bank’s ‘margin’ aka profit. One can usually get a ‘prime’ interest rate on a mortgage if your deposit or equity is more than 80%. Do you know what yours is? Credit card debt is usually around 18% which is clearly ‘expensive’ and should be avoided at all costs. Personal loan interest rates can get much higher than this – up in the high 20%s, and payday loans as much as 500%.