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Attitiude to Debt and Budgeting...

Discussion in 'Money Management' started by Simon, 21st Mar, 2006.

  1. Simon

    Simon Well-Known Member

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    Taming the Debt Monster

    So you have found yourself with a whole swag of debt. Credit cards, car loan, home loan, store cards etc etc

    Trying to pay them all off to keep the wolves from the door? But nothing ever seems to change?

    Below is a simple strategy used by some of my clients to get on top of this debt monster.

    Before I start though you need to hear a few of my thoughts on money and debt.

    Money and debt is like food. If you have the wrong attitude to food then poor health soon follows, obesity, malnutrition etc. In much the same way an overeater eats for comfort so we can spend for comfort. It is pointless trying to control debt without changing the attitudes and behaviour that led us there.

    Bad debt vs Good Debt.

    Deep down we all know what bad foods are. I suspect that deep down we know what bad debt is. As we know that broccoli is good for us so we know what good debt is. But let me explain my thoughts on it.

    Good debt is characterised by these two points.

    • The interest on the debt is tax deductible.
    • The purpose of the debt is to develop an income stream or add to your wealth.

    Some examples are:

    • Investment property loan
    • Loan for shares or managed funds
    • Even a home loan adds value to your portfolio, growing available equity but is an exception as it is not normally tax deductible. Some pundits would argue that a home loan is bad debt but lets leave this one open.

    Bad debt is characterised by:

    • Not tax deductible
    • Is used for consumer spending – Big Screen TV, Car, Holiday etc

    A simple test - will the item you bought add wealth or income over time?



    I had a poor client who had bought herself a $55 000 car thinking as a performance vehicle it would appreciate. I just couldn’t convince her that it wasn’t the case until I asked her to call the dealer she bought it from and ask him to buy it back. He offered her $25 000 she told me in tears. Sadly she decided that she couldn’t face selling it and realising the loss so she still owes that money and the car is worth even less today.

    If you are serious about getting on top of the debt monster then you must make the conscious decision to never again be a slave to bad debt.

    Promise yourself that from today you will only borrow when the loan is for purposes of improving your financial situation.

    Indulge me by reading a story from my past. When I was a young officer in the Army I couldn’t save. I desperately wanted to start investing but every time I had $1000 saved something popped up that was more important. Travel, consumer goods etc.

    So in 1993 I took myself down to the Credit Union and borrowed $5000 to buy shares in the coming Woolworths float. My reasoning that if I owed the money I would easily repay it and the interest was deductible. Enforced savings.

    I think the float price was $2.15. $5000 was about 20% of my annual income then and in today’s dollars would be double that. My friends thought I was crazy borrowing to buy shares – What if they go down in value? I asked them what they had borrowed money to buy. Cars - at least they had the certainty of knowing that their purchase was definitely going to go down in value.

    Today those Woolworths shares are trading at nearly $20. $46 500 would be the value of my $5000 long paid back. Along the line they have paid dividends (with tax credits thrown in) of just under 5%. I could have elected to take these dividends in additional shares and I don’t even want to calculate what the decision not to has cost me.

    That new car that cost $25000 is now worth what? I think you will be surprised.

    Let’s look at a 1993 Commodore as being typical of the car my mates were buying. (I owned a VC Valiant before Retro was back in! Cost me $1600 and I got $1800 when I sold it).

    Bought new in 1993

    1993 HOLDEN COMMODORE

    VP II Executive Sedan 4dr Auto 4sp 3.8i
    Trade in price guide* $1,500 - $2,700
    National average price - private sale* $2,400 - $4,200
    Price when new (RRP) $25,676

    www.redbook.com.au

    What about running costs? Let’s not even go there…..

    I think you are now realising what the lesson here is…..

    Imagine if I had the guts to spend the same amount on Woolworth’s shares as my mate did on his new car?

    I would be sitting on nearly $240 000 today. This years dividend alone would have been $6600 with tax of 30% already paid on it by Woolworths.

    What if I had spent as much as a house on them….. $100 000 worth….

    $960 000 worth of quality shares, $66 000 annual income with tax credits of 30%.......

    I don’t even want to think about this any more 

    Is the new car feeling worth that?

    Can you now see the difference between good and bad debt?


    Before we go further you need to reflect on what you have used debt for to date. Did you buy the $25 000 Commodore now worth $2500?

    My wife and I decided some years ago only to ever borrow for appreciating assets.

    This was a turning point in our wealth creation efforts.

    We are well in debt today, more so than most people according to recent surveys. But our debt is 100% tax deductible and the income from the assets we bought pays the interest bill.

    We do have a small credit card of about $2000 for convenient access to money but this is paid monthly before the interest kicks in.

    If you also can make this decision I promise that your attitude to money will start to change for the better. Remember it is a snowball effect here. The immediate effect will be small but as you look back you will notice the huge difference it makes. I know we have.

    Changing your attitude to debt is vital before you face the next step in taming the debt monster.

    Now here is the section you have been asking for.

    Simon’s Debt Reduction Strategy

    Firstly sit down and record all of your debt’s including the monthly repayments. For ease of example let’s start with typical debts of a young couple and see if we can get on top of them.

    Jack and Jill are a twenty something couple with decent incomes and high consumerism.

    They have a home loan of $250 000 and a home worth about $300 000. Home loan rate is 7% payable over 25 years.

    They own a 2 year old commodore car with a loan of $25 000, lets be generous and say it is now worth $20 000 even though a dealer would only offer them $14 000.

    2004 HOLDEN COMMODORE

    VY II Executive Sedan 4dr Auto 4sp 3.8i
    Prices based on km 30,000 - 50,000
    Trade in price guide* $13,200 - $14,900
    National average price - private sale* $16,100 - $19,000
    Price when new (RRP) $32,740

    www.redbook.com.au

    They have two credit cards with a combined limit of $10 000. 16.5% interest on the $7000 balance.

    Buying furniture and electrical goods on interest free store card finance has them another $6 000 in debt. Now the honeymoon is over they are paying 22% in interest – that’s right 22%. Did you think the Credit Providers gave Interest Free Terms because they are good blokes? They know that enough people don’t repay within the Interest Free period and will roll over into the higher rates.

    At this point many mortgage sellers (Banks, other lenders and Mortgage Brokers) will be advising them to use the equity in their home to consolidate their loans. They may even encourage taking the whole loan to a new lender and borrowing $288 000 against their home. Their reasoning is that having all the debt at 6% means it is easier to control. This is true – it will free up a substantial amount of cashflow each week.

    Here is where we need to be honest with ourselves.

    Consolidating the debt against the home loan and then paying it back over 25 years means we are still paying for this car and furniture long after it is still being enjoyed. The amount repaid will be many times the original cost.

    Only take this option if you have the discipline to continue to make the payments as though the debts have not been consolidated. Pay the extra $38 000 off in the two or three years allowed under the current arrangements – don’t extend it over the 25 years!

    However if you are not certain enough to take this risk then…

    Here is a proven strategy that is simple and works.

    Pay the minimum amount required by the lenders on every debt. Pay Interest Only (IO) on the home loan.

    Immediately direct all available funds into the smallest debt. Knock it over as fast as possible. It will take Jack and Jill a matter of a few months to pay out their store cards on their combined income. Quicker if they go without a few luxuries and take a sandwich to work instead of eating out etc.

    At this point let me interrupt and say that some people believe that they should select the highest rate loan to pay down first. This makes pure financial sense but we are not pure financial animals. Getting on top of the smallest amount fast gives the feeling of progress and success quickly. This encourages us to keep going.

    Now that we have killed the smallest debt we need to sit back and pat ourselves on the back and feel good. This good feeling is important. Associate this good feeling with the saving effort you have made. Associate the despair and feeling of being overwhelmed with overspending.

    Next we focus all our effort on the next smallest debt. We also a whole minimum monthly payment now freed up by killing the smallest debt so we can now make even faster inroads onto the second smallest debt.

    I think you get my drift here. Keep going this way until everything but the home loan is paid off. I reckon J + J can do it in a year or two if they focus.

    What now?

    Now that we have freed up a significant amount of cashflow what do we do next? Maybe buy that big screen TV? Car is 4 years old – better upgrade?

    Just like an over eater can lose weight and then relapse and end up even heavier so can an over spender get into the same trap with debt.

    This is what I mean about changing attitude to money. So many people I help make a huge effort and then very quickly get back to where they were – sometimes worse as they have a sense of security that they can act when they need to.

    What if we harness that savings ability into wealth creation?

    Lets assume that in order to kill all that debt J+J freed up $3000pm in their domestic cashflow. Now that the debts (less the home loan) are gone what should they do with that money?


    Remember that we made their home loan IO? Let’s leave it at that for now.

    But let’s put that extra $3000 per month into their home loan. This is a terrific place to store cash. Every $1000 they have in there reduces their annual interest bill by $70. Had they put there money into a savings account and earned 2% interest they would have made $20 – and paid tax on it! Plus the money is only ever a ATM visit away!!

    Keeping money in a home loan is tax free income at a higher rate than any bank will give you!

    This is where an offset account is invaluable. All the transacting in an offset account takes place in a separate account to the loan. Moving money in and out does not
    change the actual loan amount. It just varies the amount of interest charged by the lender.

    Back to J+J

    Jack and Jill now wish to make an investment. It will be for the long term and they know the difference between investing and speculating. Do you?

    An example explains it better…

    Robert Kiyosaki goes into the difference between being a speculator and investor in his book Who Took My Money. He tells a story of a cattle farmer and dairy farmer to illustrate his point. The cattle farmer raises a calf and then takes it to market to be slaughtered: at which point he gets paid and hopefully realizes a profit. This is the speculator's model. The dairy farmer raises a cow and sells the milk for years, more like a dividend paying stock or cash flow rental property. This is the investor's model.

    A speculator is in effect gambling that he will get a capital gain by holding a purchase for a short time frame An investor buys for the long term in the knowledge that he will receive an income stream and also that the established property or company will appreciate in value.

    So buying a cheap mining stock is very different to the example I gave at the beginning of this document about the ownership of a company like Woolworths.

    Jack and Jill have decided they wish to invest in another property.

    They see their broker and he advises an upper lending amount taking into account their ability to repay the loan, their security for the loan (in this case their existing equity) and their wishes. In this example he has suggested they spend $250000.

    Armed with this knowledge they start inspecting houses and units in their area. It is not my intent to discuss units vs houses nor the argument of buying locally or remotely.

    After a few weekends they find a tidy home well located, in good repair and rented to good tenants. It is returning $250pw rent.

    With their broker they decide to redraw $61 000 from their home loan to use for this purchase as follows. $50 000 as a 20% deposit, $7 200 to cover stamp duty and the remainder for sundry expenses such as legal fees and inspections.

    They ask the bank to show the new drawings as a split on their home loan so that their statement reflects the two different loans being $250 000 for their home and $58 000 for their IP. The second amount is deductible as it is used to buy an income
    producing asset. An alternative would be to open a Line of Credit account (LOC) to use only for investment purposes.

    They now approach the same lender and ask for a new home loan for 80% of the investment property. This $200 000 loan is also tax deductible.

    They now control property worth $571 000. They expect that it will perform as it has historically and double every 7-11 years.

    This story has no ending. J+J continue to limit their consumer debt and borrow to buy income producing assets.

    As well as investment property they might start a share portfolio. Using $100 000 borrowed against the further growth in value of their two properties they take it to a margin lender who lends them another $100 000. With the help of their stock market advisor they select a portfolio of quality blue chip companies with the expectation that they will perform over time.

    Lastly, I am not a financial advisor so please don’t make any investment decisions based upon what I have written. They are just examples to show the smart use of debt. As a Mortgage Broker I often see the damages caused by unbridled spending and consumer borrowing. I try and try to explain these simple concepts but people either want to get it or they just don’t. It is all about a healthy attitude to money. All the advice in the world wont change things unless you want to change your attitudes to money.

    In order to change things around you – First YOU MUST CHANGE


    I hope that you can pick up a idea or two from my post.

    Please send any feedback to

    simon@mortgagehunter.com.au

    This article may not be distributed or copied without my express permission - but if you know someone who may benefit from it then please direct them to it!
     
  2. Nigel Ward

    Nigel Ward Team InvestEd

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    Great post Simon!!!

    I agree with you 100% on the debt consolidation concept a lot of people push. If you haven't got the fiscal discipline to stay out of a mess like that then simply refinancing it at a lower interest rate over a longer period is likely to be just a deferral of the problem.

    As you so rightly point out - people just aren't rational! Economists talk about us being rational profit maximisers...bollocks! Most people are as mixed up and emotionally involved about money as they are with everything else in their lives.

    Cheers
    N.
     
  3. TryHard

    TryHard Well-Known Member

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    Excellent words Simon :)

    I still marvel at the fact my school offered a subject called "Business Principles" which involved getting great marks if you wrote really neatly on fake bank deposit and withdrawal slips, and managed to stay within the lines on some journal entry for a pretend business. It'll be fantastic when the education system can put some of the kind of wisdom available on this forum, into the heads of 16-17 year olds. I was probably 35 before the penny dropped :(

    Fact is, the individual has to be ready ... and its their environment, upbringing and personal motivation that decides if they are. Probably why Steve Navra's son is buying investment property in Hendra before he's 21, and why I was putting cases of Tooheys on a mastercard constantly at its limit when I was the same age.

    Mind you, far as I remember back then, the bloke who bought a 2 year old V8 and put mag wheels on it, got all the hottest girls. And me in my 850cc mini - (I swear I was every bit as handsome as the V8 owner) - well let's just say, I watched a lot of videos (not those type ;) ) . Given what the newish V8 costing 5 times my car might have gotten me, I may have looked on it as a good investment ;-) - back then...

    My mission is to try to make all the young people in our lives reach the 'epiphany' many years before I did. I reckon let 'em live large, but if some of the sort of wisdom you've set out here can be taught to them before mid-20's, when the hormones let a few brain cells out to graze, imagine the fun they'll be having in their late 30's ;-)

    I'm with you Simon - we're now well into "impressive" debt and its mostly deductible and we're loving every minute of it :) If someone had told me that would be the case 5 years ago (when we bought the big screen TV and leather lounge) I would have laughed...

    Now we're still watching the same telly sitting on the same lounge - and you know what - it doesn't look any different to the LCD panels on display in the home theatre shops - as long as you don't put them side by side ;-)

    Thanks for the reminders !
    Carl
     
  4. TakeStock

    TakeStock Well-Known Member

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    Thankyou for putting the effort into this post Simon. You succinctly highlight the biggest financial problem (bad debt) that a lot of people face, particularly younger folk.

    I remember facing the new sports car dilemma in 1986, just after I finished my Uni degree. I finally had some real money, and damn it, that new red Toyota Celica looked really nice! I was within an inch of buying it when an older and wiser individual had a word in my ear and told me that I would regret the decision in years to come. I pondered what he said and didn't proceed with the purchase. I am obviously very happy now that I didn't.

    However, human nature being the fickle beast that it is, people will continue to move to the dark side (bad debt) to satisfy their immediate wants.

    Patience, grasshopper, is a great virtue.

    Cheers
     
  5. TakeStock

    TakeStock Well-Known Member

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    There is no need to buy a big screen TV; just sit closer to your current TV!

    (Having said that, I did go down the plasma screen route last year)

    Cheers
     
  6. Glebe

    Glebe Well-Known Member

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    Great article Simon :)
     
  7. Jacque

    Jacque Team InvestEd

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    Great work Simon :)
    And Nigel is so right, in that emotions so easily get in the way of what should be sensible decision making. The desire for us to have particular consumer items which we know we cannot afford to (yet borrow for) is so strong within certain individuals in our society. We then justify the purchases by telling ourselves we worked hard, or we had a tough childhood, or we're only going to live once etc etc

    It takes real discipline to think outside the square and go against the grain, particularly at such a young age that you did, Simon ;) I know you're only 29 now so you must have been especially youthful when you borrowed for those Woolies shares!
     
  8. talbashan

    talbashan Well-Known Member

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    just my two pennies worth...

    before we went to Navra,my wife and I were hopeless at saving. in fact we ran up credit card bills to the tune of about $15k. as much as we tried to pay it off, the money that was put into the bill was used up by the end of the month as we were short of money. this is what we did:

    1. every month allocate an amount of money to put into the Credit cards but instead of putting it into the bank we put it into an envelope. when we got $1000 sitting there in cash, we put it into the cards and lower the limit by the same amount. we continued with this until we reached a limit of $2000 on two cards and cut up the rest.

    2. we made a budget for the month. whatever we allocated ourselves for spending (shopping, movies, restaurants etc) we took out in cash at the beginning of the month and split into 4 envelopes. at the beginning of each week we'd take out that money and that was it.

    i believe that alot of issues that are related to money ie saving, investing etc are very psychological. taking out money in cash and putting in an envelope is not a great financial idea (better to leave in a LOC and reduce the interest payment) but the psychology of having $X in your wallet and thats it for the week is a powerful saving tool in my opinion.

    we now have no bad debts and we pay everything out of money that we have (we still use the cards for the points but always pay the balance owing at the end of the month). i can't tell you the relief....

    cheers
    tal
     
  9. Jacque

    Jacque Team InvestEd

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    What a terrific real life example you are then, Tal. Well done!!
    Your story really demonstrates what a financial plan can do effectively. And with your mindset change and self discipline as well, it all adds up to a securer financial future.
     
  10. voigtstr

    voigtstr Well-Known Member

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    This is an awesome post. I'll be out of debt by the end of the year if all goes to budget (excel is good for this).
     
  11. Glebe

    Glebe Well-Known Member

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    That's great stuff Voig :)

    And yes this was a brilliant post by Simon :)
     
  12. HulbertJ

    HulbertJ Member

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    Great Post Simon,

    My wife and I have refused to take on any consumer debt since we met 4 years ago. This has been the number one cornerstone of our wealth building.

    Secondly, in the last 18 months we have been using a sensible amount of deductible debt to finance 3 IP's (1 established and 2 being built) and a direct share and managed fund portfolio which has been the accelerator of our wealth building.

    I'm a great believer that its not so much what you invest in (within reason) but more that you consistently live within your means (ie. save) and consistently invest what you do save in quality assets (whether they be residential IPs, shares, LPTs, Managed Funds, Bonds etc).

    Thanks to this simple strategy we are much closer to reaching our financial goals than i ever could have dreamed of just 5 years ago.


    Jase
     
  13. Simon

    Simon Well-Known Member

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    That simple decision to avoid all consumer debt (less PPOR) makes such a huge difference over time.

    But time is what young people feel they don't have. This is the stumbling block when selling my message. They want it all to happen now. Credit delivers immediately but wealth building doesn't ...
     
  14. Simon

    Simon Well-Known Member

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    We agonise over what to invest in but the decision is way simpler - invest in almost anything is better than not doing so. Is so easy to see in hindsight.

    Thanks for the post that got me thinking again.
     
    Last edited by a moderator: 12th Apr, 2007
  15. AndrewG

    AndrewG Well-Known Member

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    Hi Simon,
    Yes that certainly seems to be the mindset of the majority of young people, for sure. Fortunately for me, I didn't follow this mentality.

    At 18 I stated to my parents I wanted to OWN (fully paid off) my own house by age 30. I purchased a house 8ks from Adelaide's CBD that was $80,000. I was not on a flash salary, I was newly married, and my wife was only working part time. Despite this, we paid it off in 4 years (we only needed to borrow $60,000 as I had already saved $25,000 by the time I was 25).

    Moral of the story - its not what I earnt ($12-13/hour in 1995), its how I organised our finances & expenditure. And yet, we still had everything we needed, and a few luxury items. We have never owed much at all on consumer debt. We got the odd thing on interest free, but I would always divide the payments up so that we would pay the item off by the required time to avoid interest :)

    We also purchased a house "within our means", so that I could easily repay 3-4x the minimum required. I remember the fortnightly payments were a little over $200, and I had set a payment figure of $650/fortnight, for almost the entire period of my loan (it was pretty well my entire salary, we were living off my wife's part time salary for most of it). Due to us paying more than required, each fortnight we would have been paying more and more principal off. I even had a mortgage spreadsheet that I had done up, which calculated the principal & interest components so I could track it each fortnight.... so yes, I was a little "obsessed" with achieveing my goal!!!

    Anyway, we sold that house, and purchased a much bigger house when I was 29. Again, bought another house "within our means" and only had to borrow $60,000 again, which we paid off in another 4 years!!! You get the idea....

    Now, at 35, I have 7xIPs (All Adelaide & Brisbane metro) with no personal debt. No car loans, no home mortgage, and an IP LVR of 51%. It was only over the last few years that I had cracked into the $40K/year annual salary!

    So YES I believe it is potentially EASY to get ahead financially quite early on, but it is a CHOICE young people have to make. Delay your gratification a bit. You don't have to have a fancy looking house to start with. Spend within your limits. Make sensible financial decisions and save while you're living at home etc., it really is not hard.

    Andrew.
     
  16. Nigel Ward

    Nigel Ward Team InvestEd

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    Andrew

    What a fantastic story! You're living proof that it ain't how much you earn...it's what you do with it that counts!

    Well done to you!

    ps. I hope you're looking at putting all that delicious lazy equity to work :cool:

    Cheers
    N.
     
  17. HulbertJ

    HulbertJ Member

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    Andrew,

    I really enjoyed your post. Very motivational. I love reading about those like yourself that have achieved so much wealth on very modest incomes!

    I'm only 3 years younger than u but have some catching up to do with so far a fully paid PPOR in canberra, an IP (adealide) and another 2 blocks (1 in adealide and 1 in melbourne) with IPs being currently built, and a decent direct share and managed fund portfolio.

    Great Effort and Keep Going!


    Jase
     
  18. AndrewG

    AndrewG Well-Known Member

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    Jase,
    You also seem to be doing very well, good on you. My advice is to keep going! You already have a fantastic foundation on which to rapidly expand, so expand as much as possible, while being careful not to over-extend.

    Good to hear.

    Andrew.
     
  19. Redwing

    Redwing Well-Known Member

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    Great post Simon and great story Andrew, as with the others I enjoy reading posts such as these
     
  20. Alwayslooking

    Alwayslooking Well-Known Member

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    Hi Simon
    thanks for the post, good read.

    Personally for me it is about balance, enjoying today and building an asset base.

    If you can invest and also have some toys now why not. No point making money if you cant enjoy it along the way.

    AL