The Real Cost of Debt

Everyone knows that they have to pay interest when they take out a loan. It’s the price we pay to use someone else’s money to purchase something we don’t have the cash for today. But beyond that, it’s hard to comprehend just how expensive debt can be. We don’t really consider the long-term financial impact of taking out a loan, not to mention the emotional and economic toll carrying even a modest amount of debt can have.

Here are some ways debt can affect your financial well-being – these are the real costs of debt.

Interest Eats up Your Budget

Debt offers a temporary increase in your purchasing power. You can afford to buy what you want now, paying it off over time from future earnings. It is important to understand, however, that the downside of this approach is that your future earnings are now going to be spread much thinner. If you are carrying an average balance of R10,000 on your credit card, at a 21% interest rate, this revolving debt is costing you more than R175 a month in interest charges. Over a year, that adds up to more than R2100 in money spent on interest, rather than necessities or extras. The danger this presents is a cycle of credit creep. As your credit card debt increases, your interest costs and minimum payment requirements rise. If your income is not increasing, interest begins to consume a larger and larger percentage of your take-home pay every month, making you even more dependent on credit to get by. The solution is to reverse direction. Pay off all debt, no matter what kind, as fast as possible. If you are carrying credit card debt, take a cold hard look at your budget and find ways to increase your debt payments to reduce your balances sooner.

Amortisation is not Always Your Friend

First, amortisation is used in the process of paying off debt through regular principal and interest payments over time. An amortisation schedule is used to reduce the current balance on a loan, for example mortgage or car loan, through installment payments.

When you must borrow money, look for the cheapest long-term option available. This means looking at the total cost of the loan, not just the monthly payment. Let us consider an example. You need a new car and your bank agrees to loan you R200,000 over four years at 13% interest. That equates to a monthly payment of R5467. Unfortunately, that payment doesn’t fit into your budget. Your car dealer offers a monthly payment of just R4108 a month. Is it a better deal?

The truth is to lower your payment your car dealer extended the term to six years. In the end you pay R295,780 for your vehicle to the car dealer, and by the time it is yours it is two years older. With the bank you paid R262,410 for your vehicle, owning it in full after four years. You would have saved R33,370 in the two years.

You are better off, in the long run, by pushing for the shortest amortisation period you can when you take out a loan. The faster you pay off any credit, the less you pay in interest. If you need to lower your monthly payments, lower the amount of money you are borrowing. Want to use amortisation in your favour? Pay more often. If you can arrange a weekly rather than a monthly payment, then you benefit from the fact that your principle payments are being reduced faster. Make extra payments whenever possible.

Debt is a Deterrent to Saving

Easy access to cheap credit provides little incentive to save for a rainy day.

Debt prohibits your tendency to set money aside. Whether this is because your debt repayments are taking up too large a portion of your income, or because you don’t bother to save as you can just access debt (credit card) for whatever you need. The result is the same. Little savings and lots of debt.

Here’s the other reason you shouldn’t ignore saving while in debt. Depending on how much debt you have, you may have less than stellar credit. A poor credit score increases the cost of any new credit you do obtain. Purchase a car and your interest rate will be higher. However, if you have enough saved to make a larger deposit, you’re a lower risk to your lender, and it’s more likely that you’ll be able to obtain a more attractive interest rate.

Debt Limits Freedom of Choice

One of the biggest emotional costs of carrying debt is that you no longer have the finances to do what you want. If you are carrying a lot of debt, you can’t afford to take a vacation, you avoid going out, and you feel pinched.

Even good debt limits your freedom of choice. Carrying a large mortgage on a home limits your mobility. Many see this play out in times of economic crisis. Relocating for a new job means selling your house where you live today. Property prices are below norm, the sales process most likely will take longer than expected, and could force you to accept a price that are causing you a loss (either real or in what you could have earned if you were able to hang on to it until the market recovers).

If a sizeable portion of your monthly income is tied up in debt payments, what happens when something goes wrong? Your debt load might be manageable today, but what happens when you, or someone in your family, lose their job, become ill, or pass away?

This lack of freedom normally leads to bad financial decisions. When credit card repayments are already taking up 20% to 25% of your income, and you need a new car, what do you focus on? That dreaded monthly payment again. That means you look for any option that will permit you to keep up with a new car loan or lease payment. You may be forced to deal with a lender who offers low credit score loans. The downside is higher interest costs, and potentially higher fees as well.

Debt Delays Retirement

One of the fastest growing risk groups in terms of bankruptcy is pre-retirement debtors. These are individuals aged 50-59 who suddenly find their retirement plans set aside as they continue to struggle to make huge monthly debt payments. Despite a higher than average income, there are more demands today on the average 55-year-old. Sandwiched between children in education, adult children forced to return home, and aging parents, they find their income stretched further than they ever anticipated.

While every person’s retirement needs will differ, few will be able to live comfortably without any supporting savings. If you believe you are going to need to supplement your income during retirement, you will need to be able to set money aside regularly. The sad truth is, most never plan for this to be the outcome. What happens is they wake up at 55 and still find themselves buried in debt, not having been able to save up for their retirement supplement at all.

Debt Has an Unexpected Life Cycle

Regardless of age, one of the largest inherent costs of carrying debt, any debt, is the added risk factor when things go wrong. Research shows that it is the unexpected life event that often triggers the need to file bankruptcy. Most expect to pay off their debt. Often, they are surprised to find out they cannot. The main causes of bankruptcy, beyond financial mismanagement, are unplanned life events.

Even with medical care, illness and injury are the most often sited causes of bankruptcy. It is not just the obvious costs of medical bills either. When you are sick or injured, you cannot work. Without a stable income you cannot pay your bills. At first you turn to credit cards just to make ends meet, fully expecting to be able to pay these debts off once you do return to work. But what happens when you do not return to work or return to a limited income and continued medical costs?

Income reduction is also something never planned or thought out. And this does not have to be an event as severe as a permanent job loss. Your work hours may be reduced, or your income renegotiated due to economic crises. If you are carrying debt, and have no emergency fund, you are unlikely to be able to keep up. Unfortunately, using credit as a temporary stopgap often becomes a permanent problem.