When people think of debt, they usually associate it with desperate times, poor financial management and escalating money problems. But being in debt does not need to be a frightening prospect, and not all debt is bad.
Since most people will need to take out a loan at some point in their lives, it makes sense to have a clear understanding of what debt is, how it is managed and how to pay it back in the easiest and cheapest way.
What is debt?
Being in debt means owing a sum of money to somebody else. Most people borrow money when they need to make a large upfront payment for something they want or need, and do not have enough cash on hand.
They loan the lump sum from a financial institution or other source, and pledge to repay it in small regular instalments. Usually, the lender also charges interest, which is a percentage amount added to the sum borrowed – this is how the lender makes money.
When is debt good or bad?
While the ideal situation is not to be in debt at all, debt does play an important role in personal financial management and can often lead to beneficial outcomes. Assessing whether the debt is good or bad largely depends on two criteria:
1. What are you taking out a loan for?
Buying immoveable property like a house or apartment is usually a good reason to take out a loan, since this is an asset that will likely increase in value – not to mention that it provides a place for you and your family to live.
Study loans are usually also good debts – investing in education is smart because better-educated people have more skills and are more likely to get a well-paying job.
But taking out a burdensome loan to buy a yacht, a flashy car or an expensive holiday won't benefit your finances.
2. Can you repay the debt?
A good debt is one that you can easily pay with affordable regular instalments that don’t impact your other essential spending, like rent or utilities. After paying your monthly instalment, you should still have enough left over from your paycheck to save a small amount or afford a few small luxuries. This gives you a financial cushion in case you suddenly have an unforeseeable increase in expenses.
A bad debt is one that puts a considerable strain on your regular income and that leaves you with no extra cash to spend on necessities or savings.
Keep in mind that several smaller debts can put just as much strain on your wallet as one big one.
How to get out of debt
You are in a bad debt situation if you've taken on debt that you cannot afford to repay, or have not accounted for escalating costs. You're probably on a downward spiral if you've defaulted on a payment are now liable for much higher sums.
Having more debt than you can afford is a difficult situation financially and emotionally, but there are some steps you can take to put yourself back on the right track. Get started with this guide.
• Have an honest look at your monthly budget and income and cut out all the expenses that are not absolutely necessary. Even small cutbacks can quickly add up and give you more money to spend on debt repayments.
• Consider taking on extra work after hours to earn extra cash, and funnel it all into your debt.
• Find more cost-effective ways to do daily tasks – taking the bus may be cheaper than driving to work, and one chain of shops may have more affordable groceries than another.
Finally, consider consolidating your debts. Consolidation means that a broker merges all your debts and leaves you with one – usually much more affordable – regular instalment to pay. This money is distributed among the people to whom you owe money.
While this may seem like the ideal solution, consolidation usually means that you will be paying off your debts over a much longer period of time, which means you will end up paying more due to interest. Always speak to a financial advisor before taking such a drastic step.
The University of Cape Town Personal Financial Management short course is presented online throughout South Africa and starts on 29 August 2011. Contact Lyndsay on 021 447 7565 or firstname.lastname@example.org, or visit www.getsmarter.co.za for more information.