Cash flow is king. Fundamental to creating wealth is to have control of your cash flow. One of the first steps in doing so for most people is to have command over their debts. So with the recent interest rate rise spotlighting the impact of debts, this week may be a great time to share some tips on managing your debts.
Let’s start with a challenge
This newsletter is in part inspired by a recent exercise set for students at Curtin University, whom I tutor each week. They are teenagers and it is their introductory financial planning subject, so they probably know much less than you do. But why not test yourself…what would you advise the “client” to do in the following situation?
- House: valued at $400,000 with an outstanding mortgage of $200,000 on which the current interest rate is 7.5 percent per annum. Repayments of $2,000 per month.
- Cash savings of $10,000 in a high interest account earning 5.5 percent per annum. This money is earmarked for emergencies.
- Car loan of $20,000, with repayments of $500 per month, on which interest is charged at 10 percent per annum.
- Credit card maxed out at $5,000 from a recent family holiday. Only the minimum repayment of $100 is being made as they have no surplus income. The interest rate is 18 per cent per annum.
So, what options are available to the “client” to:
- Manage their debts so that they are repaid sooner
- Increase their cash flow
Read on for some tips that will help you answer the challenge. But I encourage you to write down your answer first.
Plus consider, what is your current debt situation? How does this apply to you?
Good debt and bad debt
Enthusiasts of aggressive wealth creation strategies will know that one way to create wealth is to borrow money and invest it. So how can debt be bad?
All debt isn’t necessarily bad. Bad debt is:
- Debt that is used to buy lifestyle assets (assets which don’t earn a profitable income)
- Debt on which the interest is not tax deductible
Good debt is the opposite. It is:
- Debt that is used to buy investment assets (assets which do earn a profitable income)
- Debt on which the interest is tax deductible
The first tip is to eliminate your bad debt as soon as possible. In most cases for the average Australian, do so even before you consider investing.
(There are often exceptions to every rule of thumb; but in this case those exceptions don’t suit most Australians, and are also a bit more complex than I can explain in this issue of the newsletter.)
Minimise you total interest cost
When you make a repayment on any debt a portion of that repayment goes to repaying the interest and a portion goes to repaying the principal of the loan. (The principal is the amount that you have borrowed.) The more of each repayment that is attributed to the principal the sooner the loan is repaid. If you reduce your loan interest then you will repay your loans sooner.
Generally we have a finite amount each month that we can allocate to overall repayment of debts. So how does the above fundamental knowledge help us?
The trick here is to consider all your debts together. Don’t think of them in isolation. Ask “how can I structure this to reduce my total interest bill?”
The general rule of thumb is to repay high interest debts first. Once that first, highest interest debt is fully repaid, then direct the entire repayment that was going to that debt to the new highest interest debt, as an extra repayment. You do not reduce the total amount you pay each month until all bad debts are fully repaid.
Some practical tips
If you have available savings, use them to pay off debts. The reason is that you pay tax on the interest you earn, and you earn less interest than you are paying on your debts.
If you can afford to make extra repayments above the minimum amount, then direct this extra amount to the debt that has the highest interest rate.
Always repay your credit card in full each month. If you can’t then find some other way to do so, including heavy cuts to your spending in coming months until it is repaid.
If you have made extra home loan repayments in the past and now have available redraw capacity, consider using it to repay debts that have a higher interest rate. Note that the saved interest needs to be balanced with the administrative cost of the redraw. Crunch the numbers to make sure.
Sometimes it is worth taking out a new loan at a lower interest rate to repay a debt at a higher interest rate. For example taking out a personal loan to repay a credit card debt.
If you have significant equity in your home but in addition to the remaining mortgage you have other debts such as car loans, personal loans and credit card debts then consider restructuring your home finance to combine all debts into one loan. Usually this will be at the home loan interest rate, which is often the lowest rate available so you save interest and repay your debts sooner. Again, you need to crunch the numbers to ensure that the administrative cost of refinancing does not exceed the benefits of saved interest.
Slightly tongue in cheek I share with you these last couple of tips for increasing your cash flow by managing your debts:
- Spend less than you earn
- Don’t get carried away with buying the latest lifestyle doo-dad just because of interest-free deals
- Resist the temptation to use the equity in your home to upgrade to a new house, buy a boat or car (or other lifestyle asset). There are better ways to use that equity that could give you far more sustainable lifestyle pleasure.
Having read through the tips how would you advise the client to manage their debt situation?