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Debt
Handling Your Debt
16 Sep 2022
Going into debt seems like a risky financial bet these days. Read this blog post to learn how you can keep solvent in these tumultuous and expensive times.
Whether you are taking an Econ 101 class or making decisions for trillion dollar economies, the answer to spiking inflation is increasing central bank interest rates. This basically means that central banks charge their domestic banks more to borrow money.
At the start of the year American, British, and Eurozone interest rates were around 0%. The same interest rates now (by September 16) stand at 2.5% (FED), 1.25% (ECB), and 1.75% (BoE) and they are expected to be increased several more times this year and the next.
While the intention of maintaining price stability is a worthwhile endeavor, the immediate effect on many consumers is a rise in the monthly loan repayment. Why? Well if commercial banks borrow from the central bank and then lend the money forward, they will probably pass the increased price tag on to the consumer. This then will impact your monthly loan repayments as well as credit card rates.
To give a tangible example, your monthly mortgage payment for a $300 000 house with a 20% down payment was around $1 000 on 1 January, 2022. Only eight months later, by the end of August it was $1 280. And it will still grow.
The long and short of it is that debt is no longer as appealing as it had been for the last decade or so. This blog post will embrace this new reality by answering two questions. First, should you take out a debt these days. Second, how to handle your existing debt obligations so that they don’t ruin your financial stability.
Should You Take Out A Loan?
Good debts vs bad debt
In broad terms there are two reasons people take out loans – long term betterment of one’s financial situation (good debt) or solution to an immediate necessity or desire (bad debt).
The good debt group comprises student loans, mortgages, home improvement loans, and loans for starting a business. These debts will be a valuable financial investment that will pay off over the long haul. In addition, they tend to be cheaper than their “bad” brethren.
Bad debt – like credit card overdraft, personal loans, payday loans etc. – should never be encouraged as it adds nothing to your financial wellbeing over the long term. It only satisfies a fleeting need or demand. The only reason such a debt can be justified is to temporarily deal with a personal hardship (like illness or unexpected loss of job/home).
Bad debt hardly ever creates value and is usually taken out by individuals less prudent with their finances (i.e. risky clients). Credit institutions know this, so they charge far more for these loans.
With all this in mind, the avoidance of bad debt is a no brainer. Taking it will be a seriously pricey step that in these unpredictable times will greatly increase the risks of your insolvency. In addition it will also damage your credit rating in the eyes of more established and reputable credit institutions. So it’s a lose lose.
So should you take out a loan?
With good debt, it’s a bit more tricky. I suggest asking the following questions before committing to it:
- What’s the long term projection? The pandemic policies and political rhetoric notwithstanding, central banks tend to be quite trustworthy. If they openly say that rates are still to go up, take them at their word.
- How much can I handle? Realistically evaluate your current financial situation. How much unused/saved money do you have at the end of each month? Will you be able to comfortably cover the expected monthly payment and another 20% added to it, if interest rates go up even more? Do you have enough in your emergency account to avoid a bad debt?
- What does the bank say? One thing is your capability, but another thing is how much the bank is actually willing to give you. Consult them to find out how much money you can get these days based on your credit history, current debt obligations, as well as the overall economic conditions and the bank’s risk appetite?
- Will the return justify the investment? While a couple of hundred dollars or euros a month may not seem like a lot, that money amounts to a lot over a period of time. See if it may not be worthwhile to wait a year or two for a better deal not just in terms of cheaper credit, but also in cheaper assets and services. For example, the pandemic led to prices for housing to increase dramatically, which may yet fall. If, on the other hand, you need to invest in new equipment for your business, that probably is still a reasonable choice given the income it will generate, even if the assets and the loan itself will cost more.
Dealing With Existing Debt
First thing’s first – those with fixed rate debts won’t be affected by the rising interest rates. That being said, most people have at least some debt with an adjustable interest rate. This means that their monthly repayments will go up quite significantly. This begs the question – what can you do to come out of this with healthy finances?
Audit your finances
Keeping track of your personal finances is a good idea even if the economy is not hurting. If you are facing hundreds of dollars more in monthly loan repayments, a meticulous personal finance audit is essential.
To start off, list all of your income and expenditures in a single month. The income part is simple. As for the expenditure part, divide all your outflows into three groups – essentials (payments you have to make like rent, groceries, utilities, debt repayments), wants (extra spending on leisure, eating out, travel, fancy clothes etc.), and savings (the money you put in the piggy bank each month for major purchases or your emergency fund). Using a budgeting tool (such as BePrime) will make all of this easier and understandable.
Once you have done this, figure out how big of a share of your money is in each category. The golden standard would be 50% for essentials, 30% for wants, and 20% for savings. The reason why this ratio works great, is that it leaves you plenty of room to maneuver while also leaving some room for joy in your life.
For example, if you were to face a steep rise in monthly payments, there is plenty of money to divert from your wants or savings categories. The latter should be cut last and only if there is plenty of money in your emergency fund.
Problems start to arise when the necessities category makes up over 70% of your monthly budget. Things are quite dire if the necessities share exceeds 80%. This indicates that there really isn’t any more fat to cut to keep yourself afloat if interest rates go up.
Consider your debt repayment strategy
If interest rates are bound to go up, it would be smart to get rid of the debt with the already highest interest rate or the one whose repayments are likely to go up most in near future. So if you have a credit card debt and a mortgage, assigning equal priority to both would be silly. Sure, you have to make the mortgage payment, but since credit card debt is the pricier one, tighten your belt, cut your “wants” budget for several months and pay off the financial drag of any bad debt you may still have.
Another strategy, known as the debt snowball, suggests aiming to pay off the smallest debt you have first and then moving on to bigger fish. For instance, if you have a mortgage of $200 000, a student loan of $20 000, and a car loan of $4 000, pay only the minimum monthly payment for the first two, and maximize your efforts on the smallest sum. This method helps to motivate people to repay their loans as well as keeps them on track. However, even if using the snowball method, remember the first point – prioritize the high interest loans!
Finally, refinancing your existing debt with better terms can help you get out of the debt burden faster and probably leave you with a few hundred or even thousands of dollars better off. With this you can refinance mortgages, car loans, personal loans, student loans, and even credit card debt.
Usually debt refinancing comes in the form of a debt consolidation loan. It basically is a personal loan that a credit institution (usually a bank) gives out so you can pay off your existing loans. Afterwards you just pay off the single remaining debt.
Make debt repayment a goal
Erasing your debt is just as much a goal as any other. Make it a Smart, Measurable, Achievable, Relevant, and Time-bound goal and put as much resources as you can in achieving it.
The three great things about debt repayment as a goal are that:
1) It’s simple to make it SMART;
2) It’s easy (even fun) to track, observe, and implement;
3) It’s very motivating (nothing quite beats seeing those figures go down).
The specific tasks to undertake to carry out this goal will differ person to person, but these can include:
- Getting a side-gig and devoting all that income to debt repayment;
- Committing all work bonuses and government stimulus to debt repayment;
- Increasing the share of income going to debt repayment by a certain percentage point;
- Reducing expenditure in other budget categories (for example, switch to cycling instead of driving a car to work);
- Any of the aforementioned debt-repayment strategies.
One certainty is that throughout all this debt repayment process, you’ll need a handy digital assistant to lead you through the process. That’s where BePrime comes in!
With our app you’ll be able to control your finances, goals, habits, and tasks – all essential aspects to be in charge of your debt, not the other way around!
Author: Lote Steina
Commit to it! BePrime!
Commit to it! BePrime!