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The avoidance of debt

Introduction

The next secret to wealth that we consider is the avoidance of debt.

Debt is merciless in the harm that it can do in reducing our financial wealth.

There are two options that we can implement to ensure that reaching our financial goals is not limited by the negative effects of debt.

Consider the impact of debt before you incur it.

This means understanding both the cost and the benefits of any debt before we sign the contract. Household debt comes in many forms these days so we need to be aware of all types of debt and the cost of those debt arrangements.

According to the report The Net Worth of New Zealanders (Retirement Commission and Statistics New Zealand, 2002), 46% of the population has credit card debt, 29% have mortgage debt, 24% have bank debt, 18% have hire purchase debt and 16% owe money on student loans.

The easiest way to assess the cost of debt is to use some of the Shape of Money calculators, for example, the credit card calculator and the mortgage calculator.

The calculators show very quickly the true cost of the debt. Before signing on the dotted line, consider carefully what the impact of the loan will have on your ability to achieve your financial goals.

Remember that all debt isn't bad. In addition to assessing the cost of the debt, you should also consider the benefit of taking on that loan. In some instances, debt may be helping you reach your financial goals. Debts to fund property investments or increase your education are such examples. However, the cost of debt does need to be offset against the expected increase in the value of these investments.

Continue to look at ways to reduce the outstanding debt position.

Some helpful hints:

Achieving your financial goals means sticking to your plan and to your budget. Under those circumstances, the only use you are likely to have for credit cards is to use them for the cash flow benefits. That is, pay for your purchase using your credit card, and then pay for it in full (incurring no interest) a month later when the bill comes in.

If you don't pay your credit card bills in full, you won't achieve your financial goals and you're contributing to the huge profitability of credit card companies. They charge retailers up to 5% of your purchase, then charge you up to 20% interest (and it's compounding) of the outstanding debt. At the very least, the credit card companies must be achieving their financial goals!

Check out the credit card calculator and work out what your share is of the $440 million interest that New Zealanders hand over to credit card companies each year.

The marketing of credit cards has coincided with the increase in life style shopping: "I've worked hard all week, I can spend what I want on my Saturday shop". Unfortunately, these sorts of credit card spending statements won't help you achieve your financial goals.

To do that, you'll need to make credit cards work for you:

• Immediately pay off any outstanding debt,
• Have just a single card, and
• Only use the card if you know that you'll have the cash to pay the monthly bill in full.

We can't reiterate enough the insidious nature of credit card debt. It's too easy to incur and too expensive and large to quickly remove. If you're serious about achieving your financial goals, one of the major life style changes you'll need to make is to rid yourself of the credit card chains.

the Shape of Money has addressed the topic of mortgage reduction at various times, so perhaps it's an issue you've already looked at. If not, we urge you to do so now. Debt is a major barrier to achieving your financial goals. But it's also a barrier you can do something about.

If we assume an average residential mortgage of $150,000 and interest rate of 8%, then some simple calculations with the mortgage calculator quickly demonstrate why it's worth investing some time in achieving a better deal. For example, reducing the term of such a loan from 20 to 15 years will save you around $43,000 in interest - a sum that will certainly assist in achieving your financial goals.

It's easy to watch TV tonight, but why not take an hour or two out of your evening to see what you can do to reduce your mortgage and literally save thousands of dollars.

• Can you increase the value of your repayments? In the earlier example, increasing your monthly repayment from $1,250 to $1,400 will reduce the length of your mortgage by four years from 20 to 16 years, saving you $35,000 in interest.
• Have interest rates been tracking down? Can you negotiate a lower rate? Again, using the above example, a reduction of 0.25% will save you $5,500 over the term of your 20 year mortgage.

For other tips and assistance, please check out our reducing the mortgage pages.