Have you set some solid debt limits on your household budget yet? If you haven’t, it’s high time you did.
With so much talk among politicians and in the media about Australia’s national debt levels and our ongoing budget deficit, it got me thinking. How do you assess your own household debt and know when you’re in the danger zone?
Debt can lead to ruin, or riches. It’s all a matter of degree and how it’s used.
Used appropriately, debt can build wealth. Used inappropriately, debt can destroy wealth.
As the Treasurer of your family budget, you are responsible for taking control and setting some debt limits.
So here’s my guide on how to go about it.
1. Understand the difference between good and bad debt
‘Bad’ debt is money borrowed to fund everyday expenses like groceries, a holiday, or to buy an asset that will fall in value like a car.
But regardless of what the debt is, as Claire Mackay from Quantam Financial says, “A manageable level of debt is what doesn’t give you stress. If repayments and the end goal of having the loan repaid is overwhelming, that is not a good level of debt.”
2. The warning signs
When it comes to ‘bad’ consumer debt, the warning signs are not being able to pay off credit card balances on time or the interest payments on a personal loan. They are tell tale indications your debt is getting out of control. You’re in a debt spiral and the chances are you won’t get out of it.
When it comes to ‘good’ investment debt, you can also get into trouble. You know you’re getting in over your head when you can’t meet the interest payments out of existing cash flow. Or when the value of your asset falls below the value of the loan.
3. Borrow within your means from the start
Setting debt limits starts right at the beginning. The key figure is not how much you owe or how much you can borrow, but how much you can afford to repay.
If you haven’t done your budget, you don’t know how much you can afford to repay.
So start by putting together an accurate budget listing all your income and expenses. As a general rule of thumb, Claire Mackay recommends 40 per cent of your money should be going towards housing costs (if you own your own home), 30 per cent to living and 30 per cent to saving for the future.
4. Take control of your spending
Australia has run a consistent budget deficit since the global financial crisis of 2008, which means as a nation we’re spending more than we’re earning (and using debt to keep the lights on).
So take a lesson from all those pollies in Canberra: don’t be like them.
Armed with your new budget, work out whether you’re in deficit or surplus. If you are in a deficit, look at what to cut to get back to the black.
The pie is what the pie is. What you can control is what you think of as essential living expenses and what you consider as nice to have.
5. Make extra repayments
Start with the highest interest rate debts fist, because they are costing you the most.
For example, according to Finder, the average Australian credit card debt is $2,828. At an average interest rate of between 15–20 per cent that’s a guaranteed return of around $400 a year in saved interest… just by paying off your card.
Once your credit card is paid off in full, you can focus efforts into paying off the next highest interest rate loan, for example a car loan.
6. Minimise the interest you pay
In a low interest rate environment, there are always opportunities to minimise the interest you pay. That money is always better off in your pocket than the bank’s.
Compare the market for the best rate. Don’t be afraid to negotiate with your bank or switch to a better provider if the terms stack up.
And look for product features that can help you save on interest, like mortgage-offset accounts or credit card balance transfers.
As household treasurer, if you can set some debt limits you’ll be doing well. If you borrow within your means, control your spending and minimise bad debts and interest, you are managing debt effectively… certainly better than the mob in Canberra!