Debt can be a valuable tool in our lives. It allows us to enhance our lifestyle or address urgent needs by enabling the purchase of goods, services, or assets when we lack sufficient funds. Additionally, debt can amplify financial gains by increasing the scale of investments. However, it also introduces greater risk and can affect long-term wealth creation. The obligation to repay loans with interest means that various factors can disrupt your financial plans.
Useful numbers when it comes to debt
To assess the health of your cashflow a number of key measurements are useful. Below is an overview of key factors used to assess your financial health:
- Maximum loan term: This is how long it will take to pay off all your loans
- Total interest bill: This is your total interest bill once the loans are paid off
- Debt-to-income ratio: Ths is your total debts divided by your total income
- Debt-to-asset ratio: This is your total debts as a portion of your total assets
It's important to be aware of how long it will take to pay off all your debts and how much interest you have to pay. You can then formulate plans to reduce both of these metrics as well as tracking your progress.
The debt-to-income ratio is commonly used by lenders to assess a borrower's ability to repay. They generally will not lend if the ratio is too high. A ratio less than 3.6 is considered healthy.
Another commonly used metric is the debt-to-asset ratio which shows the levels of debts you have versus your assets. A healthy debt-to-asset ratio for an individual typically falls below 15%. Ratios higher than 20% are generally considered a warning sign. This means that for every dollar of assets, having less than 15 cents in debt is seen as a good balance, while exceeding 20 cents in debt per dollar of assets could indicate financial risk.
Rules to stay on top of your debts for wealth creation
- Can you afford it? – Make sure you can afford the regular loan repayments. Work out whether you'll still be able to repay if the interest rate went up by 3%.
- Shop around – Shop around for the lowest interest rate and fees. This could save you thousands over the loan term.
- Beware of debt spirals – Look out for loan sharks. They offer easy credit but with very high interest which can snowball into a debt trap.
- Make extra repayments – Budget for extra loan repayments. You'll save a lot in interest and pay back the loan faster.
- Reduce inefficient debt as quickly as possible – Inefficient debt is debt used to purchase items that decline in value (or have no value once consumed).
- Use efficient debt to enhance your investment strategy – Efficient debt is debt used to purchase items that produce income or increase in value over time.
- Actively manage your risks – Having debts exposes you to a range of risks that could impact your ability to repay the loans. It's important to regularly review your risk mitigation measures to ensure they're fit for purpose.
Know your credit score
When you apply for a loan, the lender will look at your credit score, also known as your credit rating. This is a score that shows how responsible a borrower you are, based on your personal and financial details. Knowing this can help you negotiate better deals or understand why a lender rejected you.
Your credit score includes factors like:
- How much money you've borrowed
- How many credit applications you've completed
- Whether or not you make your loan payments on time
Depending on which agency you get your score from, it will be between 0 and 1,000 or 1,200. You can get a free copy of your credit report, which includes your credit score, every three months.
What to do if you get into debt trouble
Ask for help
Many financial counsellors offer free, independent, confidential services to help you deal with unmanageable debt. Call the National Debt Helpline at 1800 007 007 to get in touch with one.
Understand your options
It's useful to know the options available to you under the law so that you can make an informed decision. These can include formal arrangements like debt agreements, personal insolvency agreements, temporary debt protection and bankruptcy. It can also include informal arrangements directly with the creditors.
Talk to your creditors
Many providers have hardship programs that are designed to help support you through moments like these. You may be able to get more time to pay, enter a flexible payment arrangement or agree on a smaller payment to settle the debt.
