COVID-19 INFECTING YOUR DEBT AND ARE YOU DROWNING?

There is no doubt the world consumer is in deep financial trouble as the economic crunch and recession take effect with COVID-19 and lockdowns and other negative news globally.

In some countries, like South Africa, we have some added troublemakers in State Capture, corruption, Junk Status and some State-Owned Enterprises (SOE) bankrupt, to name but a few.

Does this all make you feel like you drowning or is the water still clear enough so you can see the bottom and do something about it?

One thing is for sure, you can then still do something about it, but you would want to obtain the services of a financial professional to do so.

At the same time, all debt is not bad debt and the public has to appreciate the "good, the bad and the ugly" side of debt to enable them to do something about it, while pro-actively managing debt.

While we often focus on the dangers of too much debt, debt is necessary for a modern healthy economy to grow and this is referred to as consumerism.

Just mentioning the word “debt” instils fear in many consumers. No one wants to be in a position of owing money, yet reality dictates that in some way we’ll always owe money to someone due to the obvious realisation that we can’t all afford to pay for everything in cash.

There will always be cars and houses to pay for and consumers need to consider the financial gearing principles which allow for good debt to be made and used effectively.

The assumption is that we should be doing all we can to fight debt and this is correct but it is not the ultimate objective.

"Debt it seems is always something to not have and to avoid."

There are many forms of debt, but I really want to focus in my opinion on the 3 main principles of debt; being the good, the bad and the downright ugly debt, and if it comes down to fighting the ugly side of debt, we have to sometimes become very brutal as we have seen Clint Eastwood do in a Hollywood movie with the same name. "Make my Day" and kill ugly debt!

The fact of the matter is that most of us carry some sort of debt in various versions.

The critical part is to carry the right kind of debt and to not be over-geared too much.

After all, debt is not something you should avoid; it’s something you should manage. Avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies.

"The challenge is learning how to judge which debt makes sense and which does not, and then wisely managing the money you do borrow".

Kobus Kleyn

One of the main principles of debt control, as recommended by Certified Financial Planners in general, would be that not more than 15 % of take-home pay should be allocated to debt outside of bond repayments, which may include personal loans, credit cards, overdrafts, student loans, vehicle finance and so on. So let’s reflect on the importance of carrying the right kind of debt.

GOOD DEBT

Good debt should normally provide a long-term financial payoff and the first example that come to mind would be purchasing a second property through gearing.

Gearing means multiplying your efforts through other people and financial institutions money. If you can acquire assets ( in this case a second property) that other people are willing to pay to use you effectively draw 3 rd party money into your personal money system and is therefore no longer limited to the resources that you can generate alone.

A home loan would in most cases be perceived as good debt (due to its investment value, as homes will normally appreciate over time) and especially if a structured plan is put in place with your financial planner to reduce the term from the normal 20-30 years to 7-10 years which is easier to achieve than people would anticipate.

For instance, to simply increase your bond payment annually with CPI (inflation) manually you would be surprised to see your term reduce to 10 years as you will be paying of capital and not interest only.

Another form of good debt could be an educational loan for yourself where the subsequent qualification or accreditation would improve your earnings power and should easily pay back the cost of the loan.

Vehicle finance sometimes has a double edge sword to it as it could fit into the good or bad debt category. Financing a vehicle that you need to get to work is usually justified and especially if you have a structured package which may include a car allowance or similar or if you are a commission earner or contract worker or similar and you want to reduce some tax as far as possible.

However, unlike most homes, most vehicles lose value over time, often quickly through depreciation. What would classify car finance certainly as bad and even ugly debt are gimmicks like balloon payments (residuals) and “buy now pay later” principles. Vehicle finance over 60 to 72 month instead of the accepted 36-48 month is just a disaster waiting to happen when the car has to be replaced.

There is such a thing as too much good debt and this will occur when you abusing your budget by buying the most expensive home you can possibly afford or a high-end sports car to get to work which is not financially wise if your disposable income does not allow for it. We also refer to it as keeping up with the Jones.

BAD DEBT

Bad Debt normally can be classified as debt made to buy things you do not need and can also not afford either way to pay for in cash. This would also normally be short term debt of any kind and where the debt repayments keep going on long after the item you have bought with the finance does not exist anymore or have broken or similar. There will certainly be no financial payback on such items. That holiday to Mauritius for instance that you could not do with cash, or could not afford, and where you used your access bond or credit card, would be bad debt as the enjoyment of the holiday will long be forgotten, as you keep paying it off for a year or longer.

By far the worst form of such bad debt must be personal loans and credit card debt which always come with much higher interest rates than any other finance vehicle and can be as high as 22 %. Credit card debt can become a good debt if the full outstanding amount is paid within 55 days of the purchase as no interest will be attracted with most institutional credit cards under such terms.

Another form of bad debt and which was so well used by banks before the subprime crises in 2008/2009, is debt consolidation through your home loan access bond or similar. With such facilities financial institutions want you to use a long term finance vehicle to consolidate short term debt like a vehicle, personal, credit card, overdraft and similar debt. This has an immediate impact to reduce your debt payback instalments drastically due to the much lower interest rate level and gives you a false sense of security that all is now under control.

If such debt was however managed correctly to pay the debt off still over the same term it as intended for e.g. 12-60 months and not over 20-30 years than the principle is good but this is not often the case, unfortunately.

UGLY DEBT

Ugly Debt I simply refer to as "Peter steals from Paul". This is where a creditor is running out of credit facilities through over-gearing of debt and needs to keep on taking out personal loans and applying for new credit cards with various institutions as well as increasing overdrafts and revolving credit loans. This is simply referred to " maxed out" Most of these come at high-interest rates and causes a vicious debt trap, which is never easy to come out of, as you simply digging the hole deeper and deeper.

Some other examples would be unsolicited loans through the post, email, text or call centres and unsecured loans through certain micro loan banks, interest on pawned items and retail loans from furniture shops or similar.

The worst of all would always be “loan sharks” loans that come with many other negatives which I would not go into deeper, but that Clint Eastwood would have to deal with to protect you.

An unsecured loan can be described as a “loan extended only on the basis of the borrower’s financial position, creditworthiness, credit history, and general reputation."

The borrower signs a promissory note but does not pledge any specific assets as collateral. In South Africa, we have in the past seen the impact of such loans on ABIL.

The different forms of debt mentioned above and if not managed correctly and effectively would severely impact on your standard of living over the long term and definitely on your financial planning going forward.

Living with controlled minimal debt will help create a better quality of life and could be critical to financial success and your financial plan.

Financial planners would in most cases recommend that you aggressively pay down any debt with an interest rate which runs above prime + 2 % or more.

When rates are lower than that, and if good debt, and in some cases bad debt, you should evaluate whether to pay off the debt or use the money for investments or to place the money in an emergency fund and this should really only be evaluated with your financial planner.

In conclusion, we should always consider debt in a neutral sense and be aware that there may be aspects to debt that are worth having and despite how counter-intuitive this may seem. This doesn’t mean we must always owe people money, but if we have learned with the help of financial planners how to manage such debt, it could be a good thing as it can provide you access to life opportunities that you might otherwise never have, which can result in wealth creation through gearing and other principles as discussed already.

It can take years for individuals to recover from an ugly debt situation or a financial crisis like we had globally in 2008/2009, and we will all find now with COVID-19 in 2020.

If the situation is not managed, it can spiral completely out of control for many years, with the economy growing steadily worse all the while, or with even more debt being made, and especially bad and ugly debt by individuals.

I hope the information above would be helpful to all consumers and some of you would not need Clint Eastwood to protect you or to solve your debt problems in life, but if you do need help, rather make contact with your financial planner to do so for you. Any good financial planner worth his salt will be able to help you out of the deepest dark hole of ugly debt if given the time and the opportunity.

Just make sure you get hold of the right person through affiliations and no better source than the FPI Let's Plan in South or your local country professional financial institution in any country. If not sure try the FPSB to find your local financial planning professional body.