Even “good debt” is a potential financial risk
By Hester van der Merwe
You’ve probably read a lot of articles on debt – it’s a perennial financial planning topic that’s been debated over and over again over the years. Is there no point in coming back to this subject?
There is a point, and here’s why.
According to a report by DebtBusters, a debt restructuring and advisory firm, unsecured debt has risen 53% in South Africa since 2016. This is a frightening statistic and will only get worse as the layoffs and layoffs continue as a result of the Covid. -19 pandemic.
Debt is always worth talking about because it is so easy to fall into the trap, especially in these tough economic times. But if you give yourself the knowledge, you can make the right decisions about debt and get away with it unscathed, maybe even better. Here’s what you need to know.
So-called “good” debt is taking out a loan with the goal of ultimately increasing your net worth over the long term. Good debt can include the following:
- Mortgage loan. Your home should increase in value over time and provide a roof over your head for as long as you live.
- Student loan. A qualification should improve your chances of finding a good job or starting a business.
- Commercial loan. While an injection of cash to grow your business can be considered good debt, it’s important to note that this type of loan can often be high risk. Do proper research and get expert advice.
- Vehicle financing. This is another contentious good debt because auto financing can be quite expensive and a car will start to lose value as soon as you leave the showroom. However, depending on your life and work circumstances, owning a safe and reliable car may not be an option for you. If you are in this position, be sure to make wise decisions when deciding which car to finance. It doesn’t have to be the fanciest or the newest on the market.
Bad debts should be avoided at all costs. Here are some examples :
- Credit card debt. If you don’t pay off your credit card in full at the end of each month.
- Revolving credit. Any loan that does not have a fixed repayment term.
- Clothing accounts. Or any other account allowing the purchase of consumables on credit.
- Personal loans. For whatever reason.
Life is unpredictable; everything can happen. You have to be prepared so that if you find yourself in a difficult situation, you don’t have to go into debt to survive. The best way to avoid going into debt is to have a healthy emergency fund – yet another financial planning concept that has been discussed ad nauseam! But there’s a reason for it, because it’s a fundamental part of any sound financial plan and should be ignored at your own risk.
The role of an emergency fund goes beyond protecting you from having to incur bad debts to get through a crisis. Remember that even good debt comes with some level of risk – your emergency fund should allow you to pay off your home and car payments, for example, for at least six months or up to a year. if possible. This will give you some peace of mind and prevent you from missing payments, which will negatively impact your credit rating.
Be nice to your future me
If you distill the concept of taking on debt, it basically boils down to this: You are borrowing from your future self to satisfy a present need or yearning.
Make sure you know the exact total cost of debt – any interest added over time – and write that number down. Check it out. Think about it. Then be 100% honest with yourself and decide if taking on debt is worth it or not. If that won’t serve you well in the future, give up on the idea.
Out of the frying pan …
If you find yourself in a situation where you are unable to repay your debts, don’t give in to the temptation to take on more debt to pay off your existing debts. Debt consolidation may be an option in some circumstances – it’s a form of debt refinancing that involves taking out a single loan to pay off many small loans – but be careful not to let it get out of hand.
Before taking steps to settle your debt, make sure you understand all of your options and how each of them can affect your credit rating and your future access to financial products. Seek advice from a Certified Financial Planner® – an expert will take the pressure off your decision-making and help you create a budget so you can cut spending, clear your debt and get on with your life.
Ultimately, not all debt is bad, but even “good” debt should be viewed as a potential financial risk. Take it only after careful consideration. Lean towards “Maybe” rather than a “Yes!” Enthusiastic!
Hester van der Merwe is CFP at Ultima Financial Planners and Financial Planner of the Year 2020.