Debt: the negative to the positive

WE live in a society where if you want something you can get it immediately, whether it is that big screen television, a new pair of shoes, or renovation work for your house, as access to finance is easy. But so is the debt trap you could very well find yourself in.

“Everyone wants new stuff effectively every time,” Personal Wealth Advisers principal Cameron Howlett said.

Once people are caught up in the “keeping up with the Jones’ attitude”, it is very hard to break out of it, he says. “It becomes difficult to rationalise paying things off.” And by “paying things off”, Howlett refers to the interest free finance deals at stores, on credit cards as well as loans.

“I’ll give you an example, I had a client who was in a well paying job and there was an expectation for her to look presentable and dress well,” he said. “She was in her 30s and her financial situation was that she owed about $80,000 in credit card debt and effectively had no assets to speak of.”

Howlett said she was paying 15% interest, which worked out to about $12,000 a year in interest. “What was going into her bank account she was spending, despite earning a really good income, and the interest is eating away at her capacity to pay down that debt.”

“It just gets harder and harder, and harder the longer it goes on.”

There were two options for this particular client, Howlett said. “The first, which is the most preferred, is to set up some sort of payment plan to pay off that debt over a period of time. The second solution is to declare bankruptcy, and once you declare bankruptcy that effectively means that those debts are foregone and you won’t be able to get finance for a number of years.”

This client had a goal of purchasing a house in a couple of years and if she declared bankruptcy, she was not going to be able to get finance, he said. In this particular client’s situation, she was on a good income, but just could not manage her spending patterns. “So what we ended up doing was reducing the amount of money she actually had to spend,” Howlett said. “This effectively meant cutting off all access to credit, cutting up the cards and also setting up a pattern where her fixed expenses such as phone bill, rent were automatically taken out of her weekly pay of about $5000 a fortnight.”

A separate bank account was set up for her spending money for the fortnight that was scaled back, he said. “So, there was a significant amount of surplus that was leftover that we took and put back onto the credit card.”

Paying off debt is about setting up the right payment structure, Howlett said, and living within your means. “[For this client], it meant significant cutbacks to her lifestyle in order to get her finances in order.”

At some point, debt needs to be paid back as it can affect a person’s retirement plans as well, he said. “For example, these clients a number of years ago [husband and wife] owned a property in the eastern suburbs in Melbourne that was worth a couple of million dollars. They had done major renovations to the property and had paid interest only on the loan. So effectively it meant that the debt of the property was at $800,000, while the property was worth $2 million,” Howlett said. The client was 55 years old and had a good income, but the majority of his income was going to pay the interest on this debt. “So they are asset rich and cash flow poor.”

The husband worked and had about $300,000 in super but the wife had no super and did not work. In five years time, at best, the husband could have about $600,000 in super and one option is to withdraw it to pay off some of the debt, Howlett said. “So when they both retire they could go on the aged pension, which is about $23,000 per annum. Going from a lifestyle [for these clients] where they are living on $80-90,000 per annum to $23,000 just does not work.”

The second option was to sell the property. “This is the family home and there are emotional attachments to it,” he said. “So they are stuck either way, and what caused this problem in the first place is that they did renovations on the property and only paid interest. What interest only means is that you are not paying any principal off the loan at all. This won’t reduce your debt.”

Payment plans to pay off debt is specific to each individual and dependant on who the creditors are. “It’s is important to not put yourself in the situation in the first place,” he said. “People need to understand that debt is limiting and restricts you on what you can do later on in life, it’s the minus to the plus side.”

Howlett’s advice for anyone planning on taking on significant debt is to make sure that you can at least make the interest repayments but also make the same amount in principal repayments. “So if your home loan is $400,000 with an interest rate of 6%, the key is to pay off the same amount in principal.”