While the word debt might not sound very positive, having credit can actually be to your advantage. But first, let’s look at the kind of debt that works against you. Bad debt is what happens when someone racks up credit card debt for non-essential luxury items, or borrows from informal lenders who charge excessive interest. This kind of debt always has a negative effect on your overall wealth.
Good debt, on the other hand, will help you to build wealth by funding assets that grow in value. Think about a student loan that sets you up for a career, or the mortgage loan that helps you to buy a home. This type of debt can be seen as an investment.
Good debt can turn bad, however. If you borrow too much – perhaps by buying a house you can’t afford with monthly bond repayments that are too high – you’ll soon slip into a spiral of debt.
Debt’s a funny thing that way. It has a habit of sneaking up on you. If you’re disciplined and smart about how you manage your money, however, you can stay off the path to bad debt and make the money you have borrowed work for you instead.
Avoid the debt trap
A big part of managing credit – and avoiding the dreaded debt trap – lies in understanding how your repayments add up. Andrew Davison, head of advice at Old Mutual Corporate Consultants, cautions that while it is (and always will be) more cost-effective to pay cash, many people still believe that it’s cheaper to buy on credit. After all, the monthly repayments are much lower than paying out the full amount… right?
Wrong. ‘If we only look at the immediate impact on our monthly finances, it does look like buying on credit is the more affordable option,’ he says. ‘However, if we take a step back and consider the impact over the full period of the loan, a different picture emerges and it becomes very obvious how expensive debt can be.’
So, should you buy now or save up?
Davison uses the example of, say, Jemima, who wants to buy a new table. ‘Jemima earns R5 000 a month. Although she currently spends her entire salary, she desperately wants a new dining-room table, and finds the perfect one for R25 000. Now, there are two ways that she could buy it...’
Option A sees her taking out a personal loan and paying interest every month. ‘After some rearranging of her finances, Jemima calculates that if she can squeeze her regular expenditure down to about R4 100, she can afford to borrow the R25 000. At an interest rate of 20% over 36 months, Jemima’s repayments come to R930 per month,’ Davison says.
Option B sees Jemima waiting, and not buying the table on credit. ‘If she does the same rearranging of her finances, she can “free up” the same R930 a month, which she can place in a savings account with a good interest rate – say 8%. When her salary increase comes, she furthermore resists the urge to spend all of it and ups her savings by the same percentage as her increase, which we will assume is 6%.
‘After 28 months, Jemima will have saved enough to pay cash for the table. One argument against this may be that inflation would have pushed up the price after 28 months, but this is built into my calculations,’ says Davison.
Do you see the difference? If Jemima chooses Option A, it will take her 36 months to pay off the loan. By going with Option B, she will have paid for the purchase after only 28 months – and she’ll have an extra R900 a month for eight months! What’s more, if you multiply 36 (the number of months of the loan) by R930 (the monthly repayments), the total cost of the table would have come to R33 480, R5 480 more than if she had saved up for it.
Keep it under control
‘If we only look at the immediate impact on our monthly finances, it does look like buying on credit is the more affordable option. However, if we take a step back and consider the impact over the full period of the loan, a different picture emerges and it becomes very obvious how expensive debt can be.’ – Andrew Davison, head of advice at Old Mutual Corporate Consultants
Of course, we don’t all get into debt because we want a nice new table. For many, a loan is the only way to be able to buy a car, a house or many other big items. The secret lies in taking out loans that leave you with controllable debt, and with assets that contribute to your wealth (like a car to get to work) and/or grow in value (like a house).
Use store cards, like the ones you get for clothing or furniture stores, only for essential purchases that you would have made anyway.
In addition, create and stick to a monthly budget, and don’t max out your credit card!
Most importantly, if you can’t afford to buy something, save up until you can, or simply accept that you’re better off without it. Alternatively, tell yourself to think about it for a day. More often than not, you will have forgotten about that item, or that you had wanted it, by the next day.
Credit rating 101
Lenders use your credit score (or credit rating) to predict how likely you are to repay debt. A high score (600 or more) suggests you’re very likely to pay off a loan, while a low score (490 and below) suggests that you’re at risk of defaulting (not repaying a loan).
Your credit score is influenced by factors such as your lending history and financial health. If you have missed payments on previous loans or have been declared bankrupt, your credit score will be negatively affected. When a car or property is repossessed by an institution such as a bank because you could no longer afford the monthly repayment, it will also negatively affect your credit score.
You can check your credit rating (and you should, even if you think yours is good), with a number of reputable credit bureaus. South African citizens are legally entitled to one free credit report per year from these consumer credit-rating agencies: