Debt can be compared to your shoes. You have great heels that look fabulous, but hurt like hell. You have your flats that appear boring, but are comfortable and you can still enjoy the use of your back in old age. Bad debts meaning our credit cards, car loans, furniture loans, holiday loans are like the high heels. We look fabulous in our cars, our furniture is the envy of all our friends but the monthly repayments we make are extremely painful. Good debt may not add glamour to your life e.g. loans for business or buying property but it can be used to enhance our financial security like a healthy back in old age. One of the fastest ways to increase the level of money in our pockets and hence the ability to save more is by reducing the amount of bad debt that we currently hold. We may have accumulated this debt in the past due to the tendency to spend more, or continue to add on debt consequential of our adopted lifestyles. A lot of us are caught up buying what I call ‘Flossets’ using debt. Debt reduces our available income in the short term usually because we have to service it on a monthly basis, be it credit card, consumer loan or mortgage. In the long term we pay a lot more money in interest than the amount of principle debt itself, particularly in our country where interest rates have remained relatively high.
Like with any problem, the first step towards getting out of it is a change in behaviour. The debt cycle needs to be broken. If you find yourself constantly surviving on borrowed money e.g. salary advances or constantly issuing post dated cheques to various suppliers you are living beyond your means. Solution – stop spending money that you do not have. One of the fastest ways to curb this type of ad hoc spending is via elimination of the credit card. Do not whip out the fancy gold card but pay cash or use a debit card which impacts your bank account immediately. The next is halt new unnecessary loans particularly consumer loans. Banks are currently flogging consumer loans round very corner to everyone who has a payslip. Most of the advertisements for these loans carry lifestyle related images – new car, new furniture and continue to propagate the message – “If you want something today, you can get it today with our help i.e. our loans”. We also need to stop correlating an increase in income with an equivalent increase in immediate expenditure. We tend to immediately see how we can spend more rather than how we can delay our current spending, save more so that we can be able to spend in the future.
Secondly, if you can, pay out more than the required minimum amount per month. Work with a budget and realistically see how much you can allocate towards reduction of debt. Over the long term you will end up paying much less in interest costs to the banks or financial providers. It is financially logical to start with the most expensive debt first. However my experience in consulting with individuals over the years has taught me that sometimes starting with shortest debt i.e. the one that has the shortest term remaining until it is completely paid off has its merits. The reason for this is that as human beings we do get more encouraged to proceed with something when we can see progress. Therefore paying off one debt faster will give you motivation to proceed to the next challenge because there is already a sense of achievement. If you start with the long term loans you may get discouraged along the way because you may not see results for a while.
Lastly evaluate Good Debt versus Bad Debt. In most cases the rule of thumb is to get rid of the bad debt first. Bad debt is bound to have no long term benefits to you such as a consumer loan to buy furniture. It is also usually the more expensive debt. As much as the furniture looks good in your living room, it is not appreciating in value. Good debt has a long term benefit to you and that benefit has some monetary value e.g. a business loan, mortgage taken out to buy a house or to take a course. The loan may enable the business to increase its income, the house is appreciating in value and can be rented or sold.
A common debate is whether to save more or reduce your debt. There is no right or wrong to this answer as it is dependant on the circumstances. If the debt is costing you more than the interest or benefit earned on savings, than you should endeavour to reduce the debt. If there is an opportunity to invest whereby you will earn more than the cost of the debt, than you can save more. For example if you have credit card debt of Kes 10,000 at 36% p.a. ( 3% per month) and have Kes 10,000 that you can put in a savings account earning 5% p.a., then you should reduce the debt. This is however easier said than done as many people feel better even though they have bad debt when they have a healthy savings account. One of the psychological reasons for this is referred to as ‘mental accounting’ whereby different meanings are placed on different accounts instead of looking at the overall financial picture as one. The reality is that at times hanging on to debt will negate any investment gains.
The moral of the story is that debt, especially bad debt, can be very costly just like heels to your back. It will not only reduce your ability to save in the short term but in the long term as well when your potential to earn income may be reduced. Taking charge of your debts now can be key for strong financial progress for years to come.