Qn: How do we get out of debt?

This year I have again volunteered for the Financial Planning Associations’s Ask an Expert program. Following is one of the questions I just received and my answer.

The question

Hello Matt, my husband & I own our own home but have a mortgage of nearly $300,000. It is an equity style loan, we only have approx $30,000 of equity left to use.

We are paying interest only and those payments we are finding very hard to meet, we do have a credit card which i think is probably not a good idea.

We are currently a single income family with an income of around $62,000 a year gross. But we have approx $15,000. of business related outgoings per year, this figure can go up to $20,000 a year.

We also own a half of an inheritance property worth a lot of money but the other party doesn’t want to sell.

Our question is, is there a way given our current situation that we could manage to cut down our debt and start to pay some of the money off our loan without losing our home?

My answer

As I don’t know you personally I don’t know your level of financial knowledge, so in explaining my guidance I’m going to start from some base principles. Please forgive me if this seems like statements of the bleeding obvious – it is not my intent to be patronising.

Your priority in reducing debt should be highest interest rate debt first then cascade down to lowest interest rate debt. Therefore if you have a carry-over credit card balance you nail that first, then personal and car loans and finally home mortgage. Paying off your debts in the right order is a fast way to generate spare cash for further debt repayments.

At the core the ways to reduce debt are:

  • Make lump sum additional repayments
  • Make higher regular repayments

To be able to make higher regular repayments you either need to:

  • Increase your earnings;
  • Reduce your costs (spending);
  • A combination of both of the above.

Some options to help you achieve that include:

  • Crank the business earnings
  • Get a second, even third job (Perth restaurants and cafés are crying out for staff so they can actually deliver decent service)
  • Pull your belts in so you spend less. You may need a cash flow coach to support you in creating the new habits to do that. It is a bit like a personal trainer for you money.

My article on budgeting may provide some guidance on reducing your expenses.

You can make higher lump sum repayments by selling stuff you don’t need to generate cash. Or you could even sell other investments and repurpose them to debt repayment.

If you really think you are close to losing your home and if the only other wealth you have is the inherited property then you really need to either sell it or mortgage it. A mortgage it is probably not feasible as that’ll just increase your repayments. If you haven’t done so already then perhaps tell the other owner of the inherited property that if you don’t sell then you’ll end up losing your home. Maybe they could consider buying your share from you?

To get out of a financial pickle like this it really comes down to ‘what are you prepared to do?’ There is no magic rabbit out of a hat. You have to dig deep and hustle.

Once you sort out your cash flow then it’ll be more appropriate to consider a plan. Watch my free presentation on The Six Stages of Wealth Creation to get a sense of the right next steps from there.

How much you should spend on your next house

The banks will tell you how much you can borrow. But how much should you really borrow? This article describes how to estimate the ideal maximum amount you should borrow and the true maximum affordable repayment. Follow this process so you can avoid over-extending yourself and find a harmony between lifestyle now and your future lifestyle.

These days I rarely read a non-fiction book cover-to-cover, instead I flick through to grab key ‘big ideas’ to evolve my thinking. In the past year one book I delightfully read in full was “Predictably Irrational” by behavioural economist Dan Ariely.

As I immersed myself in the insights there was one in particular, right at the very end that I read as a personal challenge. (page 285, 2009 revised edition, pbk)

Dan Ariely described how when he and his wife Sumi went to buy a house he asked some experts he knew “including a few finance professors from MIT and investment bankers” what seemed to him like a simple question.

It is a question you have probably considered too.

“How much should I spend on a house?”

Ariely describes how everyone told him the same thing – a way to calculate how much he could borrow based on his income and the interest rate. But that’s not the question he asked.

Ariely noted “when I tried to push for an answer, the experts told me that they had no way to help me figure out the ideal amount we should spend and borrow.”
(my emphasis)

Can you see why I read it as a challenge?

Well, I have the answer for you Mr Ariely (I hope one day I can call you Dan).

First, let me share Ariely’s behavioural conclusion from his experience:

“When we can’t figure out the right answer to the question facing us, we often figure out the answer to a slightly different question, and apply this answer to the original problem.”

Hopefully you can see the potential issues in that human decision making.

How much you should spend on your next house

The maximum price you should pay for your next house is the sum of:

  • Your saved deposit
  • Transaction costs
  • The maximum amount you should borrow

The maximum amount you should borrow is a function of:

  • the loan term
  • the average interest rate over the loan term
  • your maximum affordable regular repayment amount.

For definitions of the categories described in the formula below see my ‘Pay Yourself First (in practice)’ model I described in my recent article on better budgeting.

Maximum affordable loan repayment equals your net after-tax income, less allocations for:

  • Regular saving for your financial independence goal
  • Regular saving for pre-retirement essentials
  • Repayment commitments on other existing debts
  • Irregular expenses
  • Regular essential and comforts
  • Impulses and indulgences (presuming you’ll still want the occasional splurge)

Now you have estimated the ideal amount you should spend on repayments rather than some alternate rule-of-thumb like 30% of your income.

To estimate your maximum affordable loan amount you then plug that repayment amount into the free borrowing calculators provided by the lenders. Or you can do it yourself in a spread sheet using the present value (PV) function.

You can download an example calculation here.

Extra tips

By the way, don’t use what the lender says you can afford to repay each period. Their calculation ignores your need to save for eventual retirement and often assumes you can live a lifestyle equivalent to the Henderson Poverty Index (in Australia).

In completing the affordability calculation I recommend you:

  • Choose your loan term to match the amount of years until your financial independence goal. That way your debt will be repaid by ‘retirement’.
  • Add an extra 1% to the lender’s current interest rate to give you a buffer.

When you actually apply for the loan you can apply for the typical home loan term of 30 years and just plan to make extra repayments in line with your calculation. This technique also builds your buffer for if misfortune strikes.

In practice

Life is a balance between doing something that brings us immediate fulfilment and doing something else that is an investment in future fulfilment.

Exercise, healthy eating and study are often investments in future fulfilment.

If the type of home you really want to buy costs more than the above estimate you then need to make an informed trade off.

Are you willing to cut other elements of your current lifestyle? Or are you willing to cut your expectations of future lifestyle like holidays, car upgrades and retirement?

Please share your thoughts

What do you think of my recommended approach to this common dilemma? Please share your reflections in the comments below as I’d really like to know. (You can share under a pseudonym to protect your privacy.)

Is now the time to fix interest rates?

Eighteen months ago when I first wrote about fixing interest rates there had been just two RBA rate rises and fixed rates were much higher than the variable interest rates. It was also still early in the recovery and for many it may have been too early to call. So a decision not to fix interest rates may have been easier to stomach.

Now fixed interest rates are similar, even lower than the variable rate as shown in the table below. And while the RBA has recently softened its talk future rate rises seem probably to many – especially those living in boom regions. So fixing rates may be starting to look attractive to some.

Source: Cannex (accessed 20th April 2011)

History

The real problem with fixing anything for a time period is that you need to be very confident in the accuracy of your crystal ball. The last boom seemed to last long enough to affect people’s memory and lull them into thinking it would go on for much longer.

Inflation was getting uncomfortable for the RBA so rates had been up going up. That lead many of the boom-believers to fix their interest rates in the hope of beating the rises – sometimes for 3 and 5 years.

What transpired was much gnashing of teeth when interest rates plummeted, as summarised in the graph below of the RBA cash rate.

The consequence of an error-prone crystal ball can be very costly.

So should you?

For a detailed examination of the considerations in fixing rates read my earlier article. There are some circumstances when you would fix interest rates.

Right now include the following when contemplating your decision:

  • The recovery is not certain. Rates may not move for some time. So if you fix your rate you may trade off flexibility for no benefit.
  • Another sharp down-turn is possible. How will you feel if you’re paying a higher rate than the variable rate?
  • The future gets increasingly uncertain the further out you project. Exercise greater caution when considering longer terms for fixing rates.

A personal observation

In my role as a financial planner I have seen how rapidly people’s life and goals change in just a few short years. For those who fixed their interest rates (before becoming clients) I’ve noted how the lack of flexibility has inhibited their money management and wealth creation.

Don’t underestimate how quickly life evolves.

If you’ve had some big changes in the last 3 years then maybe you also will in the next 3 years – it may just be the way you roll. So,  perhaps a 3 year fixed rate is not the best thing for you right now.

B.S. from GE Money

I just heard on the radio the latest advert for the GE Money Personal Loan. It claims to give you more money to enjoy the things that matter. A lovely marketing tug on your emotions but total B.S.!

I just heard on the radio the latest advert for the GE Money Personal Loan. It claims to give you more money to enjoy the things that matter.

A lovely marketing tug on your emotions but total B.S.!

After you’ve blown the loan amount you’ll have lots of interest to repay – at a rate not much lower than credit cards. So a personal loan such as this will actually give you LESS money to enjoy the things that matter (for a long time).

Save for the significant. Minimise the insignificant.

If you really want to ensure you have enough money for those things that really matter to you follow this process:

  1. Identify those things that matter most
  2. Work out how much money you need for them, and when you’ll need it.
  3. Establish automated saving and cash flow management plans to ensure that money is there when those things that matter occur.
  4. Enjoy life with the peace of mind you’ll have the money to enjoy what really matters most.
  5. If there is any money left over you can spend it on insignificant things suchs as impulses and indulgences.

If you need a personal loan (or credit card) to fund experiences and items that matter to you take it as screaming alarm bells that your cash flow control is on fire. Run away from the lenders and towards a financial counsellor or decent financial planner.

Learn more about my cash flow coaching here.

Seventy percent of credit card debt accrues interest

“Did I just read that right?” I thought as I put down my coffee and twice re-read this paragraph:

‘Consumers are still cautious about the debt they build up on credit cards. An analysis by card operator Mastercard shows that only 70.8 per cent of the total $46.9bn in credit card debt is accruing interest, which is the lowest level in a year.’

Shoppers splash out $21bn on their credit cards” by David Uren, The Weekend Australian, February 13-14, 2010″

Over seventy percent of credit card debt is accruing interest. That’s outrageous! I hope that is a large amount of debt held by a small percentage of card holders – but I already know I hope in vain. Other research shows that around fifty percent of credit card holders regularly pay interest on their credit cards.

The first, most important rule of getting rich

It’s outrageous that in 2010 this is the case when the basic rule of personal financial management (and wealth creation) is to spend less than you earn. Such credit card statistics just reinforce the fact that as a society we are terrible at this basic rule and so we can only point the finger inward when we are dissatisfied with our financial achievements

But that is not what made me double-back over the paragraph. What astounded me was that the journalist Mr Uren described that high percentage as consumers being cautious about the debt built up on their credit cards.

Repay debt before building cash savings

On Wednesday I was again asked a question I am commonly asked by people with large credit cards debts, “should I use my cash savings to repay part of my credit card?”

Absolutely! Mathematically it is a no-brainer.

You earn less interest on your cash savings than the interest you pay on the credit card debt. So you are further ahead by actually having less cash and less debt.

After giving that advice the next thing I sometimes hear is “oh yeah but that cash is savings for a…[big holiday]”.

You’re joking right? Don’t even think about splashing out and probably getting into more debt while you’ve got this big anchor of credit card debt accruing interest. You’ll never get rich that way, let alone have enough money for what’s really important. (In the flesh I am much more diplomatic, honest.)

What do you think?

  • Am I over-reacting to be outraged and astounded by this newspaper paragraph and credit card statistic?
  • Is my suggestion about savings vs credit card to simplistic to be realistic? What makes you struggle to implement it? (share it below and I’ll reply with some suggestions.)
  • Are we perhaps not socially and behaviouraly mature enough to handle credit cards? Are they legal weapons of mass financial destruction?

Please share your opinions in the comment section below. I read them all and respond as often as I can.

To Fix Interest Rates or Not?

With two interest rate rises already under our belts more people are asking me if they should be fixing their rates. Read on to discover the pros and cons and if fixing your interest rates may be right for you.

With two interest rate rises already under our belts more people are asking me if they should be fixing their rates.

You give up flexibility for certainty plus you often pay more.

 The initial attraction to fix rates is often primal – we hate to miss an opportunity to save money. With more rate rises forecast that’s precisely what people think they’ll be doing if they fix rates.

Most get it wrong

The reality is somewhat different for most. Research has shown that over half of people who fix their rates end up worse off financially. They pay more interest and repayments than if they’d left their loans variable.

For a personal illustration of that just ask anyone who fixed their rates two years ago when there was still talk of rates going higher. That crystal ball was clearly broken.

The Rate You’ll Be Paying

One belief is that you can fix your rate at the current variable rate, so as soon as rates go up you’re in front. That is not the case. Fixed rates are set taking into consideration the lender’s forecast of rates during the fixed period.

The following table summarises rates as at 7th November 2009 from the four biggest lenders:


 


Std

Var


Basic Var

1
Year Fixed

2
Year Fixed

3
Year Fixed

5
Year Fixed


ANZ

6.31

5.61

6.50

7.34

7.69

8.04



CommonwealthBank

6.24

5.48

6.64

7.34

7.74

8.04


nab

6.24

5.74

6.59

7.29

7.59

7.89

Westpac

6.31

5.61

6.54

7.19

7.59

7.94

Source: Cannex

Ponder This: If you fix your rates now how high do variable rates need to go before you break even overall?

For and Against

Why Fix

  • You can’t keep food on the table if your repayments go much higher
  • Your mindset is that certainty is a very high priority. (Any control freaks reading this article?)

Downside Trade-offs:

  • You immediately pay a higher interest rate and higher repayments, which impacts your cash flow
  • You are very restricted on the amount of additional repayments you can make, meaning you can’t ahead as quickly as you may like.
  • There can be a break fee if you need to refinance during the fixed term (usually when your fixed rate is higher than the variable rate, like now.)

Things To Consider

What are your life plans over the next three or five years?

Your financial decisions today impact on the options you will have available to you tomorrow, next year and five years from now. If you’re not well informed some decisions you make can shut out important life choices you would like to make in coming years.

For example, let’s say you plan to upgrade your home in the next few years. If you have a fixed rate you may be liable for a large break cost. At the time the cost may be so high that you can’t afford it and end up not being able to move as desired.

Maybe you don’t plan to for certain, but maybe it’s an above fifty percent possibility. If so, wouldn’t you like to keep the option flexibly open to you?

Before fixing your rates write down all the things you think you may like to do in the coming years. Project out as far ahead as the period for which you are planning to fix your rates.

Pay rises

Right now you may not have the cash flow to make high additional repayments but keep in mind the pay rises and bonuses you may receive over the next two to three years. Wouldn’t you love to be able to use them to nail your mortgage?

Cash flow control

Remember that if your cash flow is hyper-sensitive to increased repayments then fixing rates will immediately increase your pressure. Instead, over the next few months redirect that same amount into getting some cash flow coaching. You’ll discover ways to save money that’ll actually decrease your sensitivity to rate rises.

Call or e-mail me now to enquire about my Cash Flow Coaching program.

Still Unsure?

On thing you can do is hedge your bets by splitting your loan into a variable and a fixed portion. It doesn’t need to be an even split.

If you’d like some assistance in making the decision then book a meeting with me. I’m confident you’ll have a clear decision in under an hour.

Please Share This

If you found this article to be useful please forward it to your friends who have mortgages.

3 tips to manage your mortgage stress

Have recent rises in interest rates left you feeling the strain of meeting mortgage repayments? Or perhaps are you concerned that if interest rates go much higher you will be under financial stress? If so, this interview is perfect for you.

This morning I interviewed expert Mortgage Professional, Damian Day of Ardent Finance to uncover some of the loan options that may be available to you if you are concerned about your repayments.

You will learn about:

  • The value of refinancing to consolidate debts at a lower rate
  • Where and how to shop around for a lower interest rate
  • How fixed interest rates can be used to provide cash flow security
  • The important traps of refinancing and fixing rates that could cost you much more than you gain in lower interest

The interview goes for 20mins 20 secs and could save you thousands of dollars in loan interest. I encourage you to make a cup of your favourite beverage and listen now.

For expert assistance on creating your debt structure contact Damian Day by telephone on 1300 793 813 or e-mail dday AT damianday DOT com

Six tips for choosing the best home loan

To help you choose appropriate finance products I interviewed one of Perth’s top mortgage brokers, Damian Day of Ardent Mortgage Services, and asked him to share his top tips.

To help you choose appropriate finance products I interviewed one of Perth’s top mortgage brokers, Damian Day of Ardent Mortgage Services, and asked him to share his top tips.

Here are Damian’s Six Tips:

Tip 1: Be clear on the purpose of the finance

Gone are the days when there were only a few types of mortgage structures to choose from. Now there are lots of products for all the different ways people use their money. So before speaking to a lender be clear on he purpose of the finance you are seeking. For example, is your purpose buying a new home, building, renovating, car, holiday, investing, or bridging several of the above?

Consider not just your immediate purpose but also what may happen in the foreseeable future (say 3 to 5 years).

Tip 2: Make your finance as flexible as you

Our lives change rapidly these days. We change jobs, get married, start families, move suburbs, cities, states, start businesses, buy investments all within short spaces of time. (Or is that just me?)

Over these lifestyle changes, your cash flow needs change quite a bit too. So it is important to ensure that your finance is structured with the amount of flexibility you require. Consider:

  • Is there a limit to the amount of additional repayments?
  • Can I access my extra repayments if I need to?
  • How easily can I refinance the entire arrangement?
  • Can some of the overall loan be fixed, variable, interest only?

Tip 3: Cheapest is not always the best

Tip 3a: Beware hidden fees

Years ago when the regulations on calculating comparison interest rates were introduced it was a good system. But, the lenders have since worked out how to charge you fees which are not required to be included in the calculation of the comparison rates. This makes the loan look cheaper than it really is.

Some hidden fees to be wary of include:

  • Exit fees on early repayment
  • Restructure fees
  • Lump-sum payment fees

Tip 3b: Consider the non-financial features

The money that is lent to you generally costs all lenders about the same amount. So the only way lenders can offer cheaper deals is by being more efficient or cutting out services.

Your loan may be cheap but come with no branch network, no relationship manager who cares about you, only a 1300 phone number operating on east coast time zones and limited transaction facilities. If any of those services are important to you it may be worth paying for them.

Tip 4: Ask for a package deal

Years ago these were called “Professional Packages”, but lenders have smartened up and now offer package deals based on your income and total amount borrowed. Under such deals you pay an annual package fee of around $295 to $400 and receive:

  • Low (or zero) annual fee credit card
  • Deferred establishment fees
  • No loan ongoing fees
  • You can split the total mortgage often into up to 5 parts to tailor each loan to be as flexible as your life.
  • You receive discounted variable rates, and sometimes also discounted fixed interest rates

You can access such packages with an income of around $60,000 per year and/or total amount borrowed of around $150,000. These days most mortgages are for at least that amount, so almost everyone is eligible. You just have to ask!

Tip 5: Negotiate and shop around

Lenders DO negotiate! Branch staff may tell you that it is “policy” not to negotiate. They also may not even offer you the best product from their own company. That is because, in general, they are not rewarded for winning your business and making you a happy, long-term customer. They are paid mostly (or wholly) as salary.

So be prepared to shop around to get the best deal because in Damian’s experience the lenders do negotiate most often. Well they certainly do when a mortgage broker is involved!

If you’ve enjoyed these tips and need finance you can contact Damian Day of Ardent Mortgage Services on 0409 950 975 or by e-mail at .

Increase your cash flow by managing your debts

Cash flow is king. Fundamental to creating wealth is to have control of your cash flow. One of the first steps in doing so for most people is to have command over their debts. So with the recent interest rate rise spotlighting the impact of debts, this week may be a great time to share some tips on managing your debts.

Let’s start with a challenge

This newsletter is in part inspired by a recent exercise set for students at Curtin University, whom I tutor each week. They are teenagers and it is their introductory financial planning subject, so they probably know much less than you do. But why not test yourself…what would you advise the “client” to do in the following situation?

  • House: valued at $400,000 with an outstanding mortgage of $200,000 on which the current interest rate is 7.5 percent per annum. Repayments of $2,000 per month.
  • Cash savings of $10,000 in a high interest account earning 5.5 percent per annum. This money is earmarked for emergencies.
  • Car loan of $20,000, with repayments of $500 per month, on which interest is charged at 10 percent per annum.
  • Credit card maxed out at $5,000 from a recent family holiday. Only the minimum repayment of $100 is being made as they have no surplus income. The interest rate is 18 per cent per annum.

So, what options are available to the “client” to:

  • Manage their debts so that they are repaid sooner
  • Increase their cash flow

Read on for some tips that will help you answer the challenge. But I encourage you to write down your answer first.

Plus consider, what is your current debt situation? How does this apply to you?

Good debt and bad debt

Enthusiasts of aggressive wealth creation strategies will know that one way to create wealth is to borrow money and invest it. So how can debt be bad?

All debt isn’t necessarily bad. Bad debt is:

  • Debt that is used to buy lifestyle assets (assets which don’t earn a profitable income)
  • Debt on which the interest is not tax deductible

Good debt is the opposite. It is:

  • Debt that is used to buy investment assets (assets which do earn a profitable income)
  • Debt on which the interest is tax deductible

The first tip is to eliminate your bad debt as soon as possible. In most cases for the average Australian, do so even before you consider investing.

(There are often exceptions to every rule of thumb; but in this case those exceptions don’t suit most Australians, and are also a bit more complex than I can explain in this issue of the newsletter.)

Minimise you total interest cost

When you make a repayment on any debt a portion of that repayment goes to repaying the interest and a portion goes to repaying the principal of the loan. (The principal is the amount that you have borrowed.) The more of each repayment that is attributed to the principal the sooner the loan is repaid. If you reduce your loan interest then you will repay your loans sooner.

Generally we have a finite amount each month that we can allocate to overall repayment of debts. So how does the above fundamental knowledge help us?

The trick here is to consider all your debts together. Don’t think of them in isolation. Ask “how can I structure this to reduce my total interest bill?”

The general rule of thumb is to repay high interest debts first. Once that first, highest interest debt is fully repaid, then direct the entire repayment that was going to that debt to the new highest interest debt, as an extra repayment. You do not reduce the total amount you pay each month until all bad debts are fully repaid.

Some practical tips

If you have available savings, use them to pay off debts. The reason is that you pay tax on the interest you earn, and you earn less interest than you are paying on your debts.

If you can afford to make extra repayments above the minimum amount, then direct this extra amount to the debt that has the highest interest rate.

Always repay your credit card in full each month. If you can’t then find some other way to do so, including heavy cuts to your spending in coming months until it is repaid.

If you have made extra home loan repayments in the past and now have available redraw capacity, consider using it to repay debts that have a higher interest rate. Note that the saved interest needs to be balanced with the administrative cost of the redraw. Crunch the numbers to make sure.

Sometimes it is worth taking out a new loan at a lower interest rate to repay a debt at a higher interest rate. For example taking out a personal loan to repay a credit card debt.

If you have significant equity in your home but in addition to the remaining mortgage you have other debts such as car loans, personal loans and credit card debts then consider restructuring your home finance to combine all debts into one loan. Usually this will be at the home loan interest rate, which is often the lowest rate available so you save interest and repay your debts sooner. Again, you need to crunch the numbers to ensure that the administrative cost of refinancing does not exceed the benefits of saved interest.

Bonus Tips

Slightly tongue in cheek I share with you these last couple of tips for increasing your cash flow by managing your debts:

  • Spend less than you earn
  • Don’t get carried away with buying the latest lifestyle doo-dad just because of interest-free deals
  • Resist the temptation to use the equity in your home to upgrade to a new house, buy a boat or car (or other lifestyle asset). There are better ways to use that equity that could give you far more sustainable lifestyle pleasure.

The challenge

Having read through the tips how would you advise the client to manage their debt situation?