By Sydney Sekese, CFP® professional and member of the Financial Planning Institute
The winter season is in full force with common allergies that result in most of us sneezing. An allergy is an exaggerated response to a substance and is unique to each person. Similarly, debt exposure is personal and differs from one person to the next. Being allergic to debt is recommended in this article.
I am currently reading a book by Sam Beckbessinger, a best-selling writer. She mentions in her book, that it’s quite normal for middle-class South Africans to have a credit card, and carry debt on it, only paying a minimum balance each month. This seems like a normal behaviour, however over the long term the compounding effect on the debt is frightening.
Let’s look at a practical example: Suppose you have an average R20 000 credit card balance, you pay 22% annual interest rate on it, and you carry that debt over 40 years between ages 25 and 65 and you always pay the minimum balance (usually 5%). That credit card debt ends up costing you R500 000 over that time. There’s a flip side, imagine if you invested the R1000 you were paying your credit card every month, you would have a cool R2million investment.
The above illustration confirms that by having the credit card debt, you become a “glorified slave” to your bank. Let’s unveil how banks make money. At the top level, a bank looks to balance its loan book with a savings book . The bank therefore offsets the deposits it receives by lending this money to borrowers in return for interest growth on these savings, which is effectively earned from the borrowers.
The bank must then balance how much cash it needs to have available for any savers wanting their money to be returned, as it cannot immediately get cash from its loan book. What happens in the background is that when you save by giving your money to the bank, the bank would normally loan your savings to someone else for higher interest. Perhaps it’s loaning your money to some regular person in the form of a credit card. The bank would charge that regular person an interest rate of 22% for that credit card loan. Have you wondered why the bank would seldom pay you more than 6% of your savings?
The difference between 6% and 22% is what makes the bank to exist. There has recently been an increase in the prime interest rate which mainly affects those consumers who are in debt. Many people are struggling, and some choose to bury their heads in the sand. For many in debt, the reality of owing so much money is too much to bear to face, so they simply choose not to. But sometimes, disaster strikes and people are forced to confront their circumstances head-on.
A series of unfortunate events such as a sudden job loss, an unexpected (and expensive) home repair, or a serious illness can knock one’s finances so off track they can barely keep up with their monthly payments. Debt is only dangerous if you don’t manage it carefully and reduce it as quickly as you can. Debt is here to stay and it’s a feature of modern-day society as we get bombarded by service providers who tempt us to access loans with ease.
If you use debt as a part of your bigger wealth creation strategy, it will increase your level of credit worthiness. For example, good debt would be when you take out a bond to buy a house, because in the long run you will save on rent, and you will have a good asset that hopefully increases in value over time.
Depending on the purpose, a personal loan could also qualify as a good debt, if for example it is used for as a study loan. If this personal loan is for an overseas trip, then it’s a bad debt.
Let’s compare a car to a house in terms of valuation. Car financing would be seen as bad debt because over time the value of your car depreciates. It could become a good debt if it’s repaid over a short period of time.
Bad debt also includes buying groceries on your credit card. You can do that provided you repay the full outstanding balance on or before due date. So, in a nutshell, bad debt depreciates much quicker whereas good debt has the propensity to appreciate over time with more rewarding benefits in the long term.
Final thoughts
Never use debt to fund your lifestyle. If you are in debt over clothes, or holidays, or food and parties, then you have an emergency. Cut up your credit cards, avoid store loans like you avoid your awful ex-lover. It may not happen overnight, but a debt-free future could be yours if you create a plan and stick with it long enough.
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