The good, the bad, and the ugly of debt
Debt can be a useful financial tool if it is managed correctly, and you should look out for ways in which you can make debt work for you.
There are different kinds of debt: the good, the bad, and the ugly. It is vital that you know the difference.
Good debt comes in the form of loans that allow you to turn an amount of money into something more. Examples of good debt are loans used for buying a property, doing home improvements, studying or establishing a small business.
It would take an eternity for an ordinary person to save enough to buy a house for cash, so home loans play a huge role in making property ownership affordable.
Home renovations add value to your property, so they are a good investment.
A student loan allows you to get an education and increase your long-term earning potential, while a small business loan can help you to set up or expand your business.
Bad debt is debt used for consumable items that have a short lifespan. Clothing and retail accounts, and using credit for meals at restaurants, overseas holidays, and expensive vehicles that decrease in value the minute you drive them out of the dealership, are all examples of this kind of debt.
Most credit card transactions are considered bad debt. Credit card users tend to start out being disciplined with their purchases, but end up letting things spiral out of control.
You should look at what you can afford and limit your monthly spending to below that amount. You need to pay back the debt in full every month.
A credit card can, however, be a useful tool for building a good credit rating if you can illustrate a good track record for settling your account on a monthly basis.
The ugly part of debt surfaces when you end up paying shockingly high interest rates on loans, yet have nothing to show for the money you have spent. This is often the case when people make use of so-called “loan sharks” or “mashonisas”, who make good profit on providing loans at high interest rates (up to 50%), while their customers have no legal protection. Reports show that a large number of South Africans make use of this informal service, and you are advised to try to avoid falling into this kind of debt trap.
After many demands for payment, creditors often end up handing people over to debt collectors, who are often ruthless in their attempts to get debtors to pay. They are also known to buy creditors’ debt, at a discount, and then pursue debtors to recover money now owing to them.
Tips on managing debt
* Be aware of how much is owed and to whom.
* Pay accounts on time and never skip payments.
* Draw up a monthly calendar for payments.
* Commit to paying at least the minimum required.
* Identify which debt is the most urgent to settle - usually it is the one with the highest interest rate.
* Set up a monthly budget in a bid to control your spending.
If you are trying to manage your debt, it’s important that you don’t continue accumulating it. If a rate cut does become a reality, you should use it as an opportunity to improve your situation.
Be conscious of the type and purpose of the debt you take on. Remember to protect your future self.
The right amount of good debt can help you to save for the future, free of bad debt.
Herman Lombard is the founder and executive director of investment and financial services group African Unity.