Poor debt management can be as debilitating to your financial well-being as disease can be to your physical well-being! Manage it at all levels and it can enhance your financial position.
Most of us have to deal with debt at some stage or other of our lives; and we all use debt in different ways at different stages of our lives. Managing the burden that comes with debt is an important skill.
Depending on your perspective, there are several elements to debt that need to be considered: these include (in no particular order) – ability to service the debt commitments; impact of the borrowing on other financial decisions and strategies that need to be serviced; return on investment to be made with the borrowed funds; and, the form of the loan.
When considering the ability to service debt commitments, consideration needs to be given to matters beyond the interest rate and monthly repayments. For instance, loan conditions may require a particular type and level of insurance; in some instances certain Balance Sheet indicators may need to be maintained (or other financial measures by way of ‘covenants’); and of course, what are the consequences of a ‘temporary’ interruption to the ability to meet theses commitments? Borrowers should seek advice from their financial advisors (accountants and/ or financial planners) when considering a debt/ gearing strategy to achieve some business/ investment goal.
The impact on financial freedom and flexibility to meet competing priorities needs to be considered when levels of borrowing are being undertaken that might prevent further borrowing for other purposes – whether in a business or personal investment context. In this context, it could be difficult if a decision to take on a particular level of debt put such a strain on the financial reserves of the entity that even a complementary project had to be deferred until the first borrowing was brought ‘under control’. Working to a well structured business/ financial plan will minimise the risk of such disappointment: assistance with these strategic plans should be sought from financial advisors (accountants and/ or financial planners).
The determination as to the relevant return on investment made with the borrowed funds is different as between personal expenditure, business acquisition or financial investment – but the combination of the benefits derived from making the investment (whether emotional, convenience and/ or financial return) must be sufficient to justify the costs incurred in borrowing the funds to implement the purchase/ acquisition. Where the borrowings are personal, only the borrower will be able to make the decision – where the financial elements are to be evaluated, an accountant or financial planner will be able to assist and provide guidance as to what might be considered an appropriate rate of return in the given circumstances.
The final element to be considered in relation to debt management is the form of the loan. This is a topic that could lend itself to extensive commentary alone, but here we restrict it to the decision as to how the borrowing is to be secured. A quick overview of the offerings – whilst not a complete list by any measure, all that we will deal with in this article – is as follows:-
- Unsecured personal pledge (personal loans; credit cards);
- Asset-based security (being the asset under finance) – with/ without personal pledge (home loans; car loans; margin loans; consumer credit; equipment finance); and
- Asset based security [being assets other than the item being acquired] – (segregated loans secured by mortgage: e.g., borrowing against home mortgage for personal or business/ investment purposes).
As to the most appropriate form of the loan for any particular circumstance, decisions should be based on a combination of the above factors – not purely on the cost of the loan. As a general rule debt should be addressed so as to reduce the amount on loan as quickly as is reasonable to do so, concentrating where possible on clearing ‘personal’ debt first (that is, debt that is not for income-producing or business purposes – and therefore the interest and associated costs of the debt, not tax deductible); followed by debt that is subject to particular ‘covenants’; thereafter by available variable interest-rate loans (those with the higher rate of interest before those at an interest-rate advantage).
Borrowing for any purpose is a financial decision giving rise to medium- to long-term financial commitments: making the wrong decision about the type of finance or the terms and conditions of the loan can be very costly: advice from an experienced and trusted advisor should be sought in most circumstances – and it would be remiss of such an advisor to omit discussion about protecting the serviceability of the borrower by ensuring adequate personal risk insurance is in force throughout the loan term. When the appropriate terms are decided (level of borrowing, term of loan, method of securing etc) you may then find that an experienced (mortgage) broker will help you to source the best deal available at the relevant time.
To review the debt you are currently managing; or in anticipation of any new borrowings, call Continuum Financial Planners (on 07 3421 3456) or seek an appointment utilising our online Contact Us facility.
(Originally published 31.01.2012; updated 19.07.2013)