Debt gets a bad rap because of the financial trouble it can cause. But if it’s managed well, it’s a tool that allows you to make major purchases you otherwise couldn’t afford. Most of us would never buy a house if we couldn’t borrow money to do it.
It’s also useful for investment planning. You can borrow money in order to buy income-producing growth assets such as property or shares to boost your long-term wealth, or borrow to start a business. In these cases, the interest you pay is often tax deductible.
Why debt can be bad
Debt trouble arises when we borrow money for basic living costs or for purchasing depreciating assets such as cars, boats or even a holiday. This is made worse by high interest rates. When interest rates rise, most people focus on their mortgage, forgetting completely that credit card interest rates rise as well. When credit card interest rates sneak up, your minimum monthly payment may only be taking care of interest and not the principle. Many credit cards are currently charging over 20 per cent per annum.
Another problem that compounds the situation is lack of planning. Whenever you borrow money, you should always have a debt reduction program in place to get it paid off.
For business owners, debt often arises for equipment finance, partially for cars. The banks are only too happy to loan as much as you are happy to borrow. While these loans can assist with short-term cash flow, there is potential for business owners spend more than they usually would. This creates an opportunity cost with the burden of high monthly repayments on a quickly deprecating asset; the flow-on effect is reduced cash flow for debt reduction or other wealth creation strategies.
Getting out of debt
If you’re struggling with debt and you feel that you’re in over your head, you need to think carefully about your financial direction. Here’s a simple plan that will get your debt under control:
- Consolidate your debts into the one with the lowest interest rate. This could be your home loan where interest rates are the lowest. When it comes to credit cards, keep just one with the lower credit limit and destroy the rest.
- Now, there is no point in completing Step 1 without creating a budget to ensure that you’re living within your means (where your income is higher than your expenses).
- Seek professional help with a financial adviser who can help you clarify your financial goals and work out a plan that suits your finances and lifestyle.
- Don’t borrow more unless it’s for a productive purpose such as investing or building future profits. Before borrowing, make sure you have a realistic plan for paying the money back.
- Don’t worry about ‘keeping up with the Joneses’. This is a deadly mindset that often leads us to borrow what we can’t pay back.
- For businesses, managing debtors can make or break a business. Be prompt when invoicing; if you are slack getting invoices out,customers will assume you are not in a hurry for payment. A great example for mechanics would be to leave your invoice on the passenger seat straight after the work has been completed.
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Don’t waste debt
In my role as a financial adviser I see many decisions where debt is wasted on depreciating assets. These decisions have often resulted in missed opportunities for more important asset purchases such a home or income-producing investments.
Many successful businesses that have created significant wealth for their owners started off with debt, which enabled them to purchase or build their businesses. Here are a couple of steps you should think about prior to signing any debt-related contracts.
- Will the asset purchased be worth more in five years time?
- Does the asset provide income to assist in the payment of its loan?
- Will the asset increase productivity and therefore income in your business?
If the answer is no to these, then you should question how important the purchase really is.
If you borrow money only when you need to and have a solid plan for paying it back, you can use debt as a tool. You can control your debt rather than your debt controlling you.
What are your tips for using debt to your advantage?