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 [email protected] 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!