Are you too deeply in debt?

By Bruce Cameron

This article was first published in Personal Finance magazine, 3rd Quarter 2004.

Debt is a major problem in South African households – and one definitely not restricted to the lower income groups. If you suspect you might be in over your head, brace yourself and take an honest look at these debt-defining signs.

Sign 1: You have a negative net worth. In other words, you owe more than you own.
To establish your financial status, list all your assets (everything you own and are owed) and liabilities (everything you owe). If your liabilities exceed your assets, you are technically bankrupt. Debt doesn’t come much deeper than that.

Sign 2: Your spending exceeds your income. If you are paying out more than you’re bringing in every month, you are digging yourself into debt.

Sign 3: More than 25 percent of what you earn is committed to repaying interest on debt. The more you pay in interest, the closer you are to the all-too-common debt trap of earning money only to keep up with the interest payments, rather than to pay for your living expenses. You should always keep your interest repayments to within 20 percent of your after-tax earnings.

Sign 4: One of your cheques bounced in the past three months because you did not have sufficient funds in your bank account. As a consequence, your bank considers you a high-risk customer.

Sign 5: Institutions have become less keen to lend you money, and/or they are charging you very high interest, and/or your bank account has been closed, and/or you have been asked to return a credit card. Any of these is an indication that your bank not only considers you a high-risk customer, but would rather not have you as a customer at all because you are in a debt crisis.

Sign 6: Most of your bills are two or more months in arrears and you have problems deciding which creditor to pay each month. You have a particular problem if you cannot pay your credit card in full each month.

Sign 7: You are listed with a credit checking company as a bad credit risk.

Sign 8: You consider unused credit facilities, such as the maximum limit on your credit card, as part of your wealth.

Sign 9: Someone has obtained a debt judgment against you.

Sign 10: You find you are running up debt to pay for ordinary living expenses. For example, borrowing money to pay for consumables, such as food.

Do you see the signs?
If you do, be honest with yourself: there is no easy way to get out of debt. It is tough going, but the remedies are well worth the effort in the end. Here are eight measures you must implement:

1 Cut back on unnecessary spending. This should range from the little things, such as taking sandwiches to work instead of eating out, to postponing major expenses, such as buying a new car. A new vehicle is a large outlay, particularly when it is financed with a loan. Too often the desire to own a new set of wheels is motivated by nothing more than wanting something different.
2 Do not borrow any more money, particularly from loan sharks, who charge prohibitive interest rates which could lock you into years of misery.
3 Speak to the people to whom you owe money, particularly your bank. Your bank will do its best to show you the way out of your problems. Your creditors will be more understanding of your predicament if they see you have a plan to get out of debt and are prepared to make the necessary sacrifices.
4 Reduce your interest load by first paying off high-interest, short-term debt, starting with your credit cards. If you can, switch your debt from a high-interest facility to a lower-interest one. This may be possible if you have a long-term, secured debt such as a home loan. However, you must increase your repayments on the lower-interest loan if you are to make headway at reducing your debt mountain.
5 Close accounts and tear up credit and store cards as you pay them off.
6 Do not gamble in the hope of scoring the big hit. The odds against winning are enormous.
7 Do not invest money while you have high debt. Always pay off debt before you start investing. There are two reasons for this: The first is that the interest you pay is likely to be higher than any returns on your investment. The second is that interest rates could rise, and then you would be forced to sell your investments prematurely to reduce your level of debt. This might mean selling when the value of your investments is low. You should never put yourself in a position where you might be forced to sell your investments at the wrong time for the wrong price.
8 Avoid so-called debt administrators. They consolidate your debt, but often charge very high administration charges and interest rates, thus locking you into your debt further into the future.

Life after debt
Once you have paid off your debt, you should start building up an emergency fund. Most financial advisers recommend you save the equivalent of at least three months’ after-tax income, but six months is preferable. Money in an emergency fund should be held in an accessible interest-bearing investment, earning as much interest as possible. If you can build up a sizeable lump sum, the best place for it is a money market bank account or a unit trust fund, both of which offer the best interest rates.

Do not invest your emergency fund in shares or equity unit trust funds lest markets are depressed when you need your money and you have to suffer a loss. Avoid life assurance endowments for your emergency fund, too, as they tie up your money for a minimum of five years. With all three of these investments – which are otherwise excellent vehicles for medium- to long-term savings – you also have to allow time for the costs to work their way out of the system.

Many employed people have another less obvious emergency fund. Build up as much accumulated (deferred) leave as you can and only take leave at the end of a leave cycle. This way, if you lose your job, you will be paid out in lieu of the leave you have not taken.