The debt conundrum : Even ‘good debt’ is a potential financial risk
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By Hester van der Merwe
You’ve probably read many articles about debt – it’s a perennial financial planning topic that has been debated repeatedly over the years. Surely there’s no point in revisiting this topic again?
There is a point, and here’s why.
According to a report by DebtBusters, a debt counselling and restructuring firm, unsecured debt has increased by 53% in South Africa since 2016. This is a frightening statistic and it’s only going to get worse as retrenchments and layoffs continue in the wake of the Covid-19 pandemic.
Debt is always worth talking about because it’s so easy to fall into the trap, especially in these difficult economic times. But if you empower yourself with knowledge, you can make the right decisions about debt and come through on the other side unscathed, maybe even better off. Here’s what you need to know.
So-called “good” debt is taking on a loan in a bid to ultimately increase your net worth in the long term. Good debt can include the following:
- Home loan. Your house should increase in value over time and provide a roof over your head for as long as you live.
- Student loan. A qualification should improve your prospects of finding a good job or starting a business.
- Business loan. Even though a cash injection to grow your business can be considered good debt, it’s important to note that this kind of loan can often be high-risk. Do proper research and get advice from an expert.
- Vehicle finance. This is another contentious good debt, since car finance can be quite expensive, and a car will start losing value the moment you drive off the showroom floor. However, depending on your life and work circumstances, owning a safe, reliable car might not be optional for you. If you’re in this position, be sure to make wise decisions when deciding on which car to finance. It needn’t be the fanciest or newest on the market.
Bad debt should be avoided at all costs. Some examples include:
- Credit card debt. If you don’t repay your credit card in full at the end of every month.
- Revolving credit. Any loan that doesn’t have a fixed term for repayments.
- Clothing accounts. Or any other account that allows you to buy consumables on credit.
- Personal loans. For whatever reason.
Life is unpredictable; anything can happen. You need to be prepared so that if you do find yourself in a pinch, you don’t have to go into debt to make it through. The best way to avoid getting into debt is to have a healthy emergency fund – yet another financial planning concept that has been discussed ad nauseam! But there’s a reason for this, because it’s a fundamental building block in any sound financial plan and should be ignored at your peril.
The role of an emergency fund goes further than protecting you from having to incur bad debt to get through a crisis. Remember that even good debt brings a certain level of risk to the table – your emergency fund should enable you to service the repayments on your house and car, for example, for at least six months or up to a year if possible. This will bring some peace of mind and prevent you from missing repayments, which will have a negative impact on your credit rating.
Be kind to your future self
If you distil the concept of taking on debt, it basically boils down to this: You’re borrowing from your future self to satisfy a present need or aspiration.
Make sure you know exactly what the total cost of the debt will be – all the interest added up over time – and put that figure down in writing. Look at it. Ponder it. Then be 100% honest with yourself and decide if taking on the debt is worth it or not. If it won’t serve you well in the future, scrap the idea.
Out of the frying pan…
If you find yourself in a position where you’re unable to service your debts, do not give in to the temptation of incurring more debt to pay off existing debt. Debt consolidation might be an option in certain circumstances – it’s a form of debt refinancing that involves taking out one loan to pay off many smaller loans – but be careful not to let it spiral out of control.
Before you take any action to tackle your debt, make sure you understand all the options available to you, and how each one might affect your credit rating and future access to financial products. Seek advice from a Certified Financial Planner® – an expert will take the pressure off your decision-making and help you create a budget so that you can cut down on expenses, clear your debt and move on with your life.
At the end of the day, not all debt is bad, but even “good” debt should be regarded as a potential financial risk. Only take it on after careful consideration. Lean towards “Maybe” rather than an enthusiastic, “Yes!”
Hester van der Merwe is a CFP at Ultima Financial Planners and the Financial Planner of the Year 2020.