Debt is a touching subject, and as we emerge from two years of the pandemic, many South Africans find themselves deeper in debt than ever.
In this article, we unpack different types of debt, how it affects your credit score, effective debt reduction methods, and how to effectively manage your debt.
Secured vs. Unsecured Debt
Broadly speaking, debt can be separated into two types of debt, either (a) secured debt or (b) unsecured debt. A main 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 collateral. If the borrower defaults, the lender can seize the asset and sell it to recoup some or all of its losses. Examples of secured debt include home loans, where the property is collateral, and vehicle financing, in which case your car would be the collateral for 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 harder to obtain and interest rates tend to be higher because the borrower faces 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. It is essential to monitor your credit score throughout your life, as it can affect your ability to obtain financing in the future if you want to buy a house, obtain financing for a vehicle or apply for a card. credit. Your credit score will also play an important role in determining the amount of financing you qualify for, the applicable interest rate and the terms of your loan. Additionally, many employers check applicants’ credit scores to determine if they are capable of managing their money responsibly.
To determine your credit score, the credit bureau uses a formula that takes into account your overall financial situation and history, how much you owe, and how you pay your bills. What’s important to keep in mind is that it takes time to build your credit history, so it’s a good idea to start building a good credit profile as soon as you start making money. ‘money. Ideally, one should have at least a line of credit so you can build a history on your profile – something that usually takes around six years to build.
Remember that late or default payments will negatively affect your credit score. Likewise, having too much debt and/or having too many open and unused lines of credit will negatively affect your score, so consider closing those that aren’t used regularly. To make sure you don’t miss any payments, consider setting up debit orders to ensure regular and on-time repayments. Keep in mind that when applying for a home loan, your lender will also consider your debt-to-equity ratio, so be sure to keep your debt payments below 36% of your gross income.
Good versus bad debt
When debt is incurred to achieve longer-term positive goals, it can be considered “good debt”. For example, borrowing money to pay for your education would be considered good debt because you are essentially investing in your future earning potential. Similarly, borrowing money to buy a house or to buy a car helps to improve your standard of living, your ability to find a job and to generate an income. That said, good debt should be affordable and should help build your net worth over time, which means flashy houses and cars that are beyond your financial means wouldn’t fall into the good debt category — and any payment late or missed will have a detrimental effect on your credit score.
A “bad debt” is any debt – usually unsecured – 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 are borrowing money to buy luxuries, travel abroad, or cover day-to-day expenses, you need to take a serious look at your finances and reduce your expenses below your income level.
The emotional burden of debt
Beyond practical debt management, the emotional toll of being heavily in debt cannot be underestimated. Debt can have devastating effects on mental health, self-esteem and relationships. Debt can lead to depression and anxiety, with a proven link between debt and suicide. In relationships, overspending and indebtedness are major causes of tension, resentment, friction and very often divorce.
Constantly living in a state of debt can manifest itself in physical ailments such as tension headaches, stomach ulcers, frequent infections, high blood pressure, and nervous tics. The constant calls from creditors and debt collectors can be difficult to live with and can escalate the situation and contribute to feelings of anxiety and stress. A ripple effect of living with debt is that it can lead to making irrational and risky decisions, such as investing in scams or gambling, which, in turn, can lead to regret and frustration. embarrassment.
Deleveraging strategies: avalanche versus snowball
When it comes to reducing and ultimately eliminating your debt, you can consider using the avalanche or snowball strategy, depending on what you think will work best for you. Either way, you’ll need to start by listing all of your debts, the respective interest rates attached to each debt, and the minimum monthly payment due. By using the avalanche strategy, you will pay the minimum amount due on all your debts except the most expensive debt (i.e. the one with the highest interest rate) for which you pay more than the minimum monthly repayment. Once you have paid off your most expensive debt, you will redirect this repayment to the next most expensive debt and so on until all of your debts are paid off.
Conversely, the snowball method targets your smallest debt regardless of the associated interest rate in order to psychologically benefit from the rapid repayment of a debt. Once your smallest debt is repaid, you will then redirect the repayment to the settlement of the second smallest debt, and so on. Naturally, there are pros and cons to each strategy, and it really comes down to what works for you. Ideally, find an online debt reduction calculator that can help you develop a comparative schedule using each of these strategies, then choose a method that you feel most comfortable with.
Debt Management Tips
Very few South Africans can afford to live debt-free, so the key is to get your debt under control and manage it proactively. Here are some tips to make sure your debt remains manageable in your overall financial portfolio:
- Keep a record of all your debts, applicable interest, minimum monthly repayments and due dates for those repayments. Make sure to repay at least the minimum monthly amount each 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, recognize the problem and limit the damage by locking up your credit cards.
- Establish an actual budget so you know exactly where your money is going each month. Don’t forget to include expenses that often go unaccounted for such as parking, tips and coffee to go. Be ruthless in reducing your costs.
- The categorization of “wants” and “needs” is relative to each person’s unique situation. Be realistic about what you consider a “need” and cut your fabric accordingly.
- Set realistic and achievable goals and reward yourself when you succeed.
- Proactively communicate with your credit providers if there is a risk of not being able to make your repayment. Don’t wait until you’ve defaulted.