“I took out a home equity loan to consolidate two credit cards that had been maxed out and carry out repairs to my house. I am due to get a gratuity at the end of my contract which will be renewed in a few months. Should I use this money to pay off my debt or should I rebuild my savings?”
Let’s look at three factors that can help you to make the right decisions with your money:
The price of the debt
When borrowing money, many people only think how the loan proceeds will help them to take care of their immediate money needs, but don’t consider how the loan payments will further impact their cash flow. Very often, the loan that was supposed to solve their money woes only ends up adding to their financial distress.
One of the ways to resolve your debt vs savings dilemma is to examine the effect that your debt has on your monthly budget. Download a personal budget from the financial tools section of www.financiallysmart.org and fill out your expense and income details. This will help you to see if your earnings are currently able to fulfil all your spending requirements.
If you realise that your monthly loan payment is taking up a significant portion of your budget, and that it is hindering your ability to deal with other important expenses, then you should pay off your debt. Otherwise, you may be forced to go back to using credit cards to pay your bills, and you’ll end up in a worse financial position than before you consolidated your loans.
Another consideration is the interest rate on your debt. Although loan costs are relatively low at this time, the price of debt will almost always be higher than what you could earn on a secure savings or investment account. For example, if the loan interest rate is 12 per cent per annum, and your investment would net you an eight per cent return, then you would be better off without the debt.
The purpose of the debt
Let’s now take a look at the reasons you got into debt in the first place. Although you have not explained why you had two maxed-out credit cards, I will assume that you used them to deal with expenses that your income could not cover. Like most of us, you probably also made some unwise spending choices over the years, and got carried away with using your credit.
As I have said on many occasions, if you borrow to finance an imbalance in your budget, you will only start a long-term cycle of indebtedness. If your income is insufficient to meet your needs it is impossible to successfully utilise debt to take care of the shortfall. Borrowing will only make your situation worse, as the underlying problem has not been resolved.
As they say in Jamaica, “short cut draw blood”. And quick loan fixes will only sink you into a deep, dark abyss of debt. The only way to deal with an income shortfall is to cut back on expenses wherever possible or try to earn more to plug the holes in your budget. If this is your situation, get rid of your loan and ensure that you reduce spending or increase your earnings.
Unfortunately, you have replaced your credit card debt with a home equity loan. Credit cards are unsecured, as they are not covered by any form of collateral. This is one of the reasons why the interest rate is much higher. Although the home equity loan rate is lower, you will put your property at risk if you run into difficulties paying your loan. Pay off your debt to secure your home.
The pain of the debt
Money psychology plays an important part in how people make financial decisions. In addition to looking at the numbers surrounding your debt — monthly loan repayments, budget balances and interest rates — you need to look at the emotional aspects of your indebtedness. In other words, how does being in debt make you feel?
Fear, shame, powerlessness, worry and stress are just some of the negative emotions that are commonly used to describe how people feel about their debt situations. Very often, persons with a chronic dependence on debt can get into a state of depression that ultimately affects their work, health, and their relationships with family and friends.
Some people get a false sense of security from having money in the bank and expensive trinkets while maintaining large loan balances. However, if your assets value the same amount as your liabilities, in reality your net worth is zero. You should also understand that your interest payments are actually putting your potential wealth into the coffers of your financial institution.
Although you may be able to cover your monthly loan payments right now, your financial situation could take a turn for the worse at any time, thanks to a major health challenge or job loss. Therefore, it might be best for you to start afresh with a clean slate; pay off your debt and use the previous loan repayments to fund a new savings plan.
Copyright © 2012 Cherryl Hanson Simpson. No reproduction without written consent.
Originally published in The Daily Observer, July 19, 2012
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Cherryl is a money coach and business mentor, and founder of Financially S.M.A.R.T. Services. See more of her work at www.entrepreneursinjamaica.com and www.financiallysmart.org. Contact Cherryl