Clean sweep
John Collett, Sydney Morning Herald, 31st of January 2006
The first step towards financial independence is to get your debt under control. John Collett shows that the key to success is single-mindedness.
Australians are used to being castigated over their poor savings habits and high debt levels, but the latest Australian Bureau of Statistics figures suggests the tide may be turning, with more consumers tightening their belt and taking charge of their debt.
Commonwealth Securities' equities economist, Craig James, says Australian households are getting their finances under
control after taking on a mountain of debt over the past several years on the back of rising house prices and low interest rates.
James says that personal lending commitments, which include personal loans and credit debt, have been falling for more than a year. And housing credit is growing at its slowest rate in six years.
However, the ABS data also shows that the household savings ratio remains negative, meaning we continue to spend more than we earn. So while we are starting to monitor our finances more closely, we have yet to do more.
The task of getting debt under control is not as difficult or as daunting as it seems. Coming up with strategies to tame the monster is easy - it is implementing them and sticking to them that requires large doses of will power.
The strategies are mostly straightforward, such as reducing borrowing costs by finding cheaper products (lower interest rates), and by making bigger, more frequent repayments to clear the debt faster.
However, before you can implement such strategies you need to know how bad your finances are, and for that you need to get a fix on where your money is going. That's where you will spot how much of your spending is on frivolous items.
Once you've done that, you will be able to draw up a family budget. This will require the input of your partner and the need to be realistic.
Separate accounts should be established for long-term savings, payment of bills and everyday spending, say financial counsellors and financial planners.
"What it gets back to is discipline," says Laura Menschik, a financial planner and the managing director of WLM Financial Services.
Most people need to structure their finances to make it easier for them to be disciplined, she says.
By having separate accounts, the bills, such as electricity, phone and rates, can be paid by automatic electronic transfer, Menschik says.
"You shouldn't have to think 'it's Tuesday, I'd better go online and transfer $1000'," Menschik says. Trying to manage from day to day is a sure-fire recipe for failure.
Interest savings
There are two simple ways to clear debt quickly: use only low interest rate products, and pay the bank more than you need to. For example, paying off just a little more greatly reduces the amount of interest paid and the term of the loan.
Researcher InfoChoice has done the numbers on a $200,000 loan over 25 years at 7.32 per cent. InfoChoice says if the borrower was to split the monthly repayment in half and pay $727.32 each fortnight, which is an extra repayment of $56.33 a fortnight, the saving would be $50,963 and four years and seven months would be slashed from the loan term.
Michael Hutton, a financial planning partner with HLB Mann Judd, says when taking out a loan you should set the repayment date for the day after payday to reduce the loan balance as soon as possible.
Consolidate debts
Menschik recommends to most of her clients that they consolidate their debts. That is where a higher interest personal loan for, say, a car is pooled with a lower interest rate mortgage.
Provided they have the discipline, Menschik favours a line-of-credit or equity-style mortgage, where the borrower has use of a "revolving" line of credit. However, she says that in the hands of a spendthrift such a product could backfire.
To succeed, the consumer needs to cut spending and increase repayments. These loans work differently from the ordinary principle-and-interest type of loan, where repayments ensure you are repaying some of the capital. With revolving line-of-credit products, only the interest needs to be serviced.
In the wrong hands the loans can saddle consumers with even greater debt, warns the manager of the Consumer Credit Legal Centre, Carolyn Bond. "There is no easy way out when you are over your head."
While some financial institutions and mortgage brokers market line-of-credit-style home loans as a solution, Bond says consumers must recognise potential traps.
Some have higher interest rates than standard home loans.
Bond says consumers may be better off staying with the loan they have and increasing their repayments on the higher-interest debt, such as the credit card debt.
Hutton points out another trap. He says refinancing a car loan from five years to 20 years will push up the cost of finance even if there is a slight rate benefit.
"I have seen people pay out their car loan and redraw it on their mortgage," Hutton says.
"But the problem is when they whack the $40,000 for the car onto their mortgage and pay it off over 20 years.
"In a few years they may have a car worth hardly anything, but have a continuing liability over 20 years that is generating interest."
He says it is important to maintain the repayments that were going towards the car at the same level when rolling over into a consolidated loan.
Credit Cards
When people get into trouble with their finances, the credit card is often where it first shows up.
David Tennant, the director of Care Financial Counselling Service in Canberra, says a quarter of those who contact the centre want help with their credit card debt.
"But it is usually not just about the credit card," Tennant says.
"The card has been used to mask inabilities or incapacities to stretch the family income to meet the demands that have been put upon it."
A recent survey commissioned by the Institute of Chartered Accountants shows that consumers with three or more cards have an average debt of $4387, compared to $1183 for those with one card.
The survey also shows those with multiple cards were much more likely to carry their card debts over into the following month than someone with a single card.
Those struggling with credit card debts are likely to be paying a lot of interest.
If debt is not paid off in full within the interest-free period, interest is charged on the entire balance at between 10 and 19 per cent a year.
Also, with cash advances there is no interest-free period; the consumer incurs interest on the cash advance from day one.
Those on the merry-go-round of credit card debt need to look seriously at how they are going to reduce their debt.
Store cards
The Australian Securities and Investments Commission's deputy director for consumer protection, Delia Rickard, says to be wary of store cards.
Interest-free terms are offered by many department stores on purchases made on store credit cards for up to two years. They may have establishment fees, typically
about $25, as well as monthly transaction fees of about $3.
Rickard says purchases not paid off within the interest-free period attract very high rates of interest, sometimes as much as 30 per cent a year compared to the 10 to 19 per cent of standard credit cards.
Prioritise debt
The priority should be to pay off "bad debt" first: that which funds consumption, not investment. This is where the interest is not tax deductible, such as the credit card debt and personal loans.
"Good debt" refers to loans taken out for income-producing purposes, such as loans on investment property and margin loans to buy shares. With loans for investment purposes the interest is tax deductible.
Hutton says the best strategy is to pay off the non-deductible debt with the highest interest rate first. For most consumers that will mean the credit card should be given priority.
The car loan should come next, followed by the mortgage.
The mortgage is not a "bad" debt because it is funding an asset that is free of capital gains tax.
However, people need to ensure that they are not overcommitted and are able to save for retirement too.
Hutton says the last debt to be paid off are the loans for investment purposes.
Where to find help
For advice with debt problems:
- Victoria: Financial & Consumer Rights Council (03) 9663 2000 can refer you to your local, free, financial counselling service.
- NSW: The Credit and Debt Hotline can give advice or refer consumers to a free service. 1800 808 488.
Older and deeper in debt
The core of those contacting the Care Financial Counselling Service in Canberra for assistance are those on low incomes.
But the centre'a director, David Tennant, says its counsellors are seeing more higher-income earners and older people, including retirees, in trouble.
He says people are carrying debt later into their life. Some are helping their kids to enter high-priced capital city property markets. Some have been forced to give up work earlier than they would have liked and struggle to maintain loan re-payments.
Laura Menschik, a financial planner and managing director of WLM Financial Services, says some people are putting themselves in a position where they are risking it all.
"They are borrowing it all against the house to go into some risky scheme or to start a business that may falter, and then they find themselves without a business and without the house," she says.
Some of those who are retrenched buy themselves a small business or a franchise. But taking on a lot of debt in your 50s or 60s does not leave much time to recover financially if the venture fails, Menschik says.
It pays to shop around
New truck sales consultant Debra Hollingsworth wanted to borrow more to make improvements to the 17-acre property where she pursues her life-long passion for horses.
She was not happy with the valuation the credit union put on her property
and she decided to shop around to see if she could borrow the money more cheaply.
Hollingsworth says the credit union was becoming more "like a bank", with her feeling like a number rather than a lifelong customer.
"It was just typical bank stuff; I just wanted to get away from that," she says.
Late last year she made the switch to credit union IMB.
By consolidating her car loan and her mortgage with the new lender, Hollingsworth says she is saving $70 a week.
Top 10 tips to flatten debt
- Start the year by drawing up a budget.
- Separate savings accounts from everyday accounts.
- Have household bills (electricity, phone, water) paid by automatic electronic transfers.
- Pay off your credit card debt within the interest-free period.
- If the credit card debt cannot be paid off, in full, within the interest-free period, shop around for a card with a lower interest rate.
- Prioritise debts to be paid off. Put "bad debt"; high-interest rate, non tax-deductible debt, at the top of the list to be paid off.
- Check in whose name the investment and the loan should be held to maximise the tax advantages.
- Pay off your debts more frequently so that the balance reduces more quickly.
- Consider consolidating debts. But be careful - interest rates can be higher on line-of-credit loans than owner-occupied mortgages.
- Use any cash such as tax cuts, bonuses and windfalls to pay off debt.
