Your debt and what it means in your portfolio

Debt is an emotive subject and, as we emerge from two years of the pandemic, many South Africans find themselves more indebted than ever before. In this article, we unpack different types of debt, how it affects your credit score, effective methods of debt reduction, and how to manage your debt efficiently.

Secured versus unsecured debt

Generally speaking, debt can be separated into two types of debt, being either (a) secured or (b) unsecured debt. A primary feature of secured debt is that it is backed by collateral, which is essentially an item of value that the borrower offers to the lender as security. If the borrower defaults on his payments, the lender can seize the asset and sell it to recoup all or some of their losses. Examples of secured debt include home loans, where the property stands as collateral, and vehicle finance, in which case your car would be the collateral to the loan. In general, secured debt is easier to obtain and the interest on secured debt is lower because the borrower is at less risk. Conversely, unsecured debt can be more difficult to obtain, and the interest rates tend to be higher because the borrower faces a higher risk in the absence of collateral. The nature of your debt and the associated interest rates will be determining factors when putting a debt reduction or elimination plan in place.

Your credit score

Simply put, your credit score is a measure of your ability to pay your bills and manage your debt. The higher your score, the less risk you pose to the lender. Looking after your credit score throughout your life is essential as it can impact on your ability to obtain financing in the future should you wish to purchase a home, secure finance a vehicle, or apply for a credit card. Your credit score will also play an important role in determining how much finance you qualify for, the applicable interest rate, and the terms of your loan. Further, many employers check the credit scores of applicants to determine whether they are able to manage their money responsibly. In determining your credit score, the credit bureau employs a formula that takes into account your overall financial background and history, how much debt you have, and how your pay your bills. What is important to keep in mind is that it takes time to build your credit history, so it is advisable to begin constructing a good credit profile as soon as you begin earning. Ideally, one should hold at least one line of credit so that you can build a history on your profile – something which generally takes around six years to build. Remember, at late or default payments will adversely affect your credit score. Similarly, holding too much debt and/or having too many open, unused lines of credit will reflect poorly on your score, so consider closing down those that are not used regularly. To ensure that you do not miss any payments, consider setting up debit orders to ensure regular and timeous repayments. Keep in mind that, when applying for a home loan, your lender will also take into account your debt-to-income ratio, so be sure to keep your debt repayments to below 36% of your gross income.

Good versus bad debt

Where debt is incurred to achieve positive, longer-term goals, it can be considered ‘good debt’. For instance, borrowing money to pay for your studies would be considered good debt as you are essentially investing in your future earning potential. Similarly, borrowing money to buy a home or to purchase a car helps to improve your standard of living, your ability to secure employment and generate an income. That said, good debt should be affordable and should work towards increasing your net worth over time, meaning that flashy homes and cars that are beyond your financial means would not fall into the category of good debt – and any late or missed payments will have a detrimental effect on your credit score. ‘Bad debt’ is any debt – generally unsecured – that is incurred to cover lifestyle expenses, or to purchase items that do not increase in value such as clothing, cell phones and groceries. This means that if you’re borrowing money to purchase luxuries, travel overseas or cover your day-to-day living expenses, you need to take serious stock of your finances and cut back your expenditure to below the level of your income.

The emotional burden of debt

Over and above the practical management of debt, the emotional burden of being heavily indebted cannot be underestimated. Debt can have devastating effects on one’s mental health, self-esteem, and relationships. Indebtedness can lead to depression and anxiety, with a proven link between debt and suicide. In the context of relationships, overspending and debt is a major cause of tension, resentment, friction and very often divorce. Living constantly in a state of indebtedness can manifest in physical ailments such as tension headaches, stomach ulcers, frequent infections, high blood pressure and nervous tics. Constant calls from creditors and debt collectors can be difficult to live with, and can exacerbate the situation and contribute to the feelings of anxiety and stress. A knock-on effect of living with debt is that it can lead one to make irrational, risky decisions such as investing in scams or gambling which, in turn, can lead to regret and embarrassment.

Debt reduction strategies: Avalanche versus snowball

When it comes to reducing and ultimately eliminating your debt, you can consider using either the avalanche or the snowball strategy, depending on what you feel will work best for you. Either way, you will need to begin by listing all your debt, the respective interest rates attached to each debt, and the minimum monthly payment due. When employing the avalanche strategy, you will pay the minimum amount owing on all your debts with the exception of the most expensive debt (i.e. that with the highest interest rate) towards which you will pay more than the minimum monthly repayment. Once you have paid off your most expensive debt, you will redirect that repayment to the next most expensive debt and so on until all your debt has been settled. Conversely, the snowball method targets your smallest debt regardless of the associated interest rate with a view to benefiting psychologically from paying off one debt quickly. Once your smallest debt has been paid off, you will then redirect the repayment towards settling the second smallest debt, and so on. Naturally, there are advantages and disadvantages to each strategy, and it really boils down to what works for you. Ideally, find an online debt reduction calculator that can help you develop a comparative timeline using each of these strategies, and then pick a method that you feel most comfortable with.

Debt management tips

Very few South Africans can afford to live without debt, so the key is to bring your debt under control and to proactively manage it. Here are some tips to ensure that your indebtedness remains manageable within your overall financial portfolio:

  • Keep a record of all your debt, applicable interest, minimum monthly repayments and the due dates for those repayments. Ensure that you repay at least the minimum monthly amount every month and on time.
  • Consider the current interest rate environment and the effect that future rate increases will have on your repayments. Ideally, create a buffer by paying more than you owe each month.
  • If you have a spending problem, acknowledge the problem and contain the damage by locking away your credit cards.
  • Draw up an actual budget so that you know exactly where your money is going each month. Don’t forget to include often unaccounted for expenses such as parking, tipping and take-away coffee. Be ruthless in cutting your costs.
  • Categorising ‘wants’ and ‘needs’ is relative to each person’s unique situation. Be realistic about what you consider a ‘need’ and cut your cloth accordingly.
  • Set yourself realistic, achievable goals and reward yourself when you succeed.
  • Communicate proactively with your credit providers if there is any risk of not being able to make your repayment. Do not wait until you have defaulted.

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