With the average South African saving less than two percent of their income, it’s no wonder so many of us are in debt. As Paul Leonard, executive director of Consolidated Financial Planning, says, if you don’t have a plan for your money, you’ll end up following the plan that someone else has for your money.
“And believe me, ‘they’ have a plan,” he says. Clearly, “their” plan is working: of the 19 million South Africans with credit records, nine million have impaired records, Leonard says.
Part of the problem is that few people fully appreciate the real cost of debt, Leonard says.
To illustrate what he means, Leonard uses the example of Bob, who earns R600 000 a year (or R50 000 a month). Bob is 40 and has only 20 working years left until he reaches retirement. But the gap between Bob’s earnings and his lifestyle is enormous. Bob has debt, but he doesn’t realize what it’s costing him.
Bob has a mortgage bond of R500 000. His bond is financed over 20 years and he is paying interest at 9.5 percent a year. His installments are R4 660.66 a month.
Bob pays his monthly installments and no more, so he will pay a total of R1 118 558.40 over the term of his bond. Of that, R618 558.40 will be in interest alone.
Bob’s annual interest rate is 9.5 percent, but in effect he will pay cumulative interest of 123.7 percent. The interest Bob will pay on his bond represents a lost opportunity, Leonard says.
Bob drives a car that costs R200 000. His car is financed over five years (60 months), and he pays interest of 10 percent. Bob’s installments are R4 249.41 a month. By the time Bob has paid off his car, it will have cost him a total of R254 964.60 – of which R54 964.60 will have been in interest. Although his annual interest rate is 10 percent, in effect he will pay cumulative interest of 27.5 percent.
If Bob were to resist upgrading his and his wife’s cars every five years, he would have an opportunity to invest. If he invested just the interest he spends on paying off his car, he could make almost R2 million in 40 years, assuming he earned a return of 10 percent a year.
To understand the true cost of debt, you need to understand compound interest.
“Being in debt is like rolling a snowball uphill, against gravity, whereas investing is like rolling a snowball downhill, working with gravity,” he says.
The longer you take to pay off debt, the more interest you pay. But the sooner you start to invest, the more interest you earn, and, as your snowball rolls downhill, the bigger it gets.
Usually, we have a snowball that we’re pushing uphill (our debts) and once we’re rolling downhill (our savings/assets). If that’s the case, remember that your net wealth is your assets less your liabilities. A bank will seldom, if ever, pay you as much as it charges you. The interest you pay on debt is higher than the interest you earn on investments, so you want to have more investments than debts.
Every debt-reduction strategy involves increasing your cash flow (earning more) or an injection of capital. Because most people earn a fixed salary or wage and have limited opportunity to earn more, Leonard says, the only way to increase cash flow is by cutting back on expenses (see “How to free up cash flow”, below).
Leonard says he has helped clients get out of debt in less than five years, using the following rapid debt reduction strategy.
1. List your debts from the smallest to the largest;
2. Look at the total debt and the total installment – in other words, view your debt as one amount;
3. Commit yourself to paying that amount until it is settled; and
4. Pay your debts off from smallest to largest.
5. You’ll find that within a matter of months you will have paid off one or more of your smallest debts. As you settle the smaller debts, re-allocate the repayments of these to the debt that’s now at the top of your list, such as your car. Eventually, you’ll be pumping excess into your home loan.
Leonard says the economic argument is to settle the debt with the highest interest rate first.
“However, the behavioral argument is to settle the smallest debt first. You see results more quickly, which increases the likelihood that you will stick to the plan, and it also frees up cash flow more easily.”