Debt – just how big a problem is it?

Debt – just how big a problem is it?

Debt – just how big a problem is it?

Recent figures show personal debt levels in Australia are among the highest in the world. So does this mean we’re heading for a debt disaster? Or are we doing the right kind of borrowing to get ahead with finances? Find out what kind of debts can be a problem and how to keep borrowing within safe limits.

Top five in the world for debt

In Australia, being in some kind of debt is far from unusual. In recent figures published by Finder, Australia takes the number four spot in the top five countries with the highest levels of household debt, behind Denmark, the Netherlands and Norway and just ahead of Switzerland.

So should this be cause for concern for Australia as a nation and as individuals? If you take a closer look at the types of borrowing that make up our personal debt, the news may not be as bad as it seems. The majority of loan balances come in the form of either mortgages (56.3%)  or investment debt (36.5%)[1]. As these debts fund assets – like shares or property – with the potential to grow in value and earn income, they’re generally considered to be ‘good’ debts.

A mortgage, for example, pays for a roof over your head now, as well as a home you’ll one day own, that could be worth more than you paid for it. And if it’s an investment property, interest on the debt may be tax-deductible, and you may earn a decent income in the form of rent. “Borrowing to buy a home is what I would call productive debt,” says Peter Foley CFP®, Director and Principal of Thirdview. “It might not be the very best type of debt, because it’s not tax deductible. But a home is often the foundation for your other life goals, a soft place to land in the midst of a hectic lifestyle and somewhere to create security for a growing family.” Borrowing to buy a new car, on the other hand is far from productive. You need a vehicle to get from A to B, but it’s a depreciating asset.”

Easy access to credit

Personal borrowing for cars, holidays and other consumer goods falls into the ‘bad’ debt category. Building up a credit card balance you can’t afford to pay off in full is in this category too and perhaps the worst kind of debt trap. “Credit card debt is just so easy to come by and hard to get rid of,” says Peter. “These days people can apply for a credit card online and start spending right away. And if you only make minimum repayments, you could be in debt for decades.”

Even though high interest rates for credit cards might be seen as a deterrent for this kind of borrowing, Peter can well understand why people get carried away. “When long-term financial goals, like buying a home, seem so hard to reach, people become disheartened,” says Peter. “So they settle for immediate satisfaction instead, without really considering what it’s going to cost them. It’s a danger for anyone, but particularly for a younger person who may not appreciate how long-term debt can impact everything from their credit history and ability to buy a home to their future relationships and plans to have kids.”

Moving beyond bad debt

The extent of the bad debt problem in Australia isn’t huge when compared to our good debt levels. Only 5% of personal borrowing is held in either credit cards (1.9%) or personal loans (3.1%)[2]. But a 2018 report from the Australian Investments and Securities Commission (ASIC) presented alarming figures about credit card debt. 18.5% of consumers are struggling with their debts and it’s costing them $1.5 billion a year in fees, including annual and late payment fees. Of the $45 billion held in outstanding balances on credit cards, $31.7 billion is being charged interest[3].

If you’re one of these 1.9 million people battling to get ahead with credit card debts, Peter suggests a couple of strategies to try. “Assuming you’ve got more than one loan or credit card balance to pay off, there are two quite different approaches to getting rid of all your debts,” says Peter. “The avalanche method is probably better known and involves paying as much as you can towards the debt with the highest interest first. The thinking here is that you’re saving yourself more in interest this way. “

“The snowball method prioritises debts in order of size. So you put more of your repayments towards the smallest balance first. When this debt is settled, you can redirect more of your cash flow to the next smallest so you build up some momentum and that’s where the snowball effect comes in. The satisfaction and sense of achievement you’ll get from having one less debt to deal can also give you the motivation you need to keep going on your mission to get completely debt-free.”

Deciding between the snowball and avalanche strategies really depends on how disciplined you’re going to be in sticking to repayment targets. This also holds true for debt consolidation or transferring credit card balances to benefit from a 0% or reduced interest rate offer. Paying less interest on existing debts can only be a good thing, but not if it means you’ll be running up new debts on your current credit cards. If you think you could be tempted to do this, it may be time to think about ways to change your spending habits.

Looking for more tips on how to borrow responsibly? Get tips from a CERTIFIED FINANCIAL PLANNER® professional on when it’s ok to borrow money and the right way to do it.

 

[1] Finder, Australians’ household debt nears highest worldwide, 31 October 2018

https://www.finder.com.au/australias-personal-debt-reported-as-highest-in-the-world

[2] Finder, Australians’ household debt nears highest worldwide, 31 October 2018

https://www.finder.com.au/australias-personal-debt-reported-as-highest-in-the-world

[3] ASIC credit card infographic, July 2018, https://download.asic.gov.au/media/4800801/asic-credit-card-infographic-4-july-2018.pdf



Online source: Produced by The Financial Financial Planning Association of Australia and published on 29 November 2018.  Original article.

Money & Life By The Financial Planning Association of Australia


 

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