Debt. Most people have it. Nobody wants it.

2015-07-07 06:31

It should be understood that personal finance is as much about your mind as it is about maths. Your relationship with money and what role it plays in your life has a definite impact on the kinds of decisions you make as to how you spend your money and how you invest your money. More often than not, the effects of the mind are more harmful or counter-productive than they are helpful.

There are however times when personal finance is about choosing an irrational path, or making your own. Like dieting, sometimes personal finance is about what you CAN do rather than what you should do.

If you’re looking for more thoughts on matters money and personal finance, I would suggest you pay a visit to WellSpent.

Getting rid of debt.

Before I dive right in and elaborate, allow me to presume two things regarding debt:

  • You probably have some debt – And that’s fine. We borrow from our future selves to live the life we want – now, including having a roof over our heads.
  • Debt is bad – We think this fairly obvious. This is the debt that we incur to buy new cars and other things we can’t afford.

Don’t get me wrong, there are times where debt is not a bad thing. Buying a home is something that offers both tangible and intangible benefits, and is not something I take issue with when financed under a traditional home loan.

This conversation however, is about the bad debt. I want to offer you a couple of ways in which you can work to get rid of that bad debt as well as present an option that is unconventionally effective.

The banks own you.

Debt comes in many forms, but I’ve categorised them into these two simple types to make this discussion easier for you.

Unsecured, short-term loans.

These are the personal loans and credit card balances that are not secured. Whether or not debt is ‘secured’ is an important concept to understand. Unsecured debt simply means that the person who has lent you the money has not taken any security for the money loaned.

If the bank lends you money for your house, they take security by placing a mortgage over your property, such that should you default on the loan they would be able to get their money first, before you’d be entitled to anything on a sale.

When you use your credit card to buy something and dip into money that you don’t have, that is essentially an unsecured loan – no different to approaching your bank and asking for a personal loan. The banks have however made it a lot easier for you to access this loan facility, so that you’re more likely to use it.

As these types of debt are unsecured, the banks are taking on more risk. More risk requires more reward, as I’ll discuss in more detail in the not-to-distant future, and for the banks - that means charging you more interest.

It is also easier for the bank to advance you unsecured amounts as the duration of these loans are typically shorter. A loan over a shorter period means there is less chance that you won’t repay the bank.

A personal loan might have a 12 month repayment period. A credit card balance generally requires you to repay 10% or 5% of the outstanding balance per month.

Secured loans

The rates of interest on secured loans are generally much less than unsecured loans as the security gives the bank more comfort that they won’t lose money on their dealings with you. Car and house purchases are generally secured, as these are large amounts of money that the banks are parting with and they’re not prepared to take that much risk on just your ‘word’ that you’ll pay them back.

The term of these loans typically ranges from 5 years to 30 years, with rates of interest often half of that of an unsecured loan.

Paying off your debt the conventional way.

If you are in a position where having considered your monthly budget and you have some disposable cash available, you’d do well to consider dealing with any debt balances you may have.

The prevailing wisdom for getting rid of debt goes something like this:

  • Consider what debt you currently have that is costing you the most. This would be the debt on which you’re paying the most interest.
  • Continue to meet your monthly debt obligations by paying the least amount you can get away with each month on each other debt, except for the one you’ve identified as being the most expensive.
  • Use all your available cash to pay off that expensive debt as quickly as possible.
  • Once you have paid off your most expensive debt, identify the next most expensive debt and pay that off.
  • Rinse repeat.

  This approach is understandably logical and most financial commentators would suggest this as the most effective method of paying down your debt. Approaching your debt in this manner, you’ll pay the least amount of interest over the life of all your outstanding balances. Paying off your debt the other way. A different approach would be to try something that has been called the ‘debt-snowball’ method. This requires you to rank your debts in order of outstanding balance and rather than attempt to pay off the most expensive one soonest, focus on that debt that has the least amount outstanding.

Here, your goal is to see progress. Rather than chip away at a massive debt balance over years and years and perhaps lose the will to persist along the way, tackle that store card that only requires you to pay R2, 400 until you’ve paid it all back.

It’s unconventional in that it sets you up on a course to pay more interest to your creditors than is needed, but it makes up for it in presenting a strategy for seeing visible progress in your mission to repay your debt.

What’s your definition of progress?

Both methods will result in progress, but it’s how you define progress that sets the methods apart. For one person, knowing that by being ‘correct’ in tackling their expensive debt first, they feel good. For them the outcome is binary. I’m doing the best I can at this, or I’m not. To consider an option that means paying more makes no sense and holds no appeal.

For someone else, paying down a smaller debt and ticking that off of a list of debts is invaluable in fueling their motivation, despite not saving on their interest costs in the long run.

So how does this play out?

It may be that either method affords you the same relief as it is likely that any unsecured loans you might have will be the most expensive. Unsecured loans are also likely to be smaller than any secured, home loans or vehicle finance that you might have.

This means you have no excuse to win at both.

So you may find that having to choose between these 2 methods is not necessary.

It would not be rare though to find yourself in the situation where your credit card balance that sees you paying interest at 17.5% is much bigger than a smaller store debt where interest is being charged at 15%. It is a situation like this where adopting an unconventional approach to paying down your debt could be considered.

The conventional approach will always beat the unconventional approach, economically speaking, IF you have the discipline to not give up and carry on paying your most expensive debt consistently. The reality is however that not everyone has that discipline, and the sense of having paid off an entire debt could mean so much more to someone than knowing that they’re winning at maths.

It’s all about what works for you.

Ultimately you must do what works for you and if this article does anything for you, it’s to give you permission to choose a method that isn’t what your financial advisor might suggest, or even what your clued-up colleagues might propose, but that still helps you deal with your debt.

If you’ve been living a life of debt failure for too long, consider taking an unconventional approach and give it a go.

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