Wednesday, January 7, 2015

Getting a Better Understanding of Debt

Most people come to the point of realising they need a change in their financial habits only when they are suddenly faced with a mountain of debt that they are struggling to repay. For the most part, we have as a society become comfortable with carrying various amounts of debts once the repayments are small enough.

The problem with this outlook is that it leads people to take on several debts which on their own are manageable but when compiled together, the total minimum payments far exceed what the person can afford to pay.

This slippery debt slope is often compounded by regular monthly bills and you may end up having to chose between keeping the lights on in the house, or putting gas in the car. 

It goes without saying that being in debt comes with various stresses and problems when it reaches the stage were you are robbing Peter to pay Paul. If you or a loved one is in this situation, you know that it is an unhealthy state and you should be working pro-actively to turn this situation around. 

When looking at your specific debts or if you are not in any debt yet and considering taking on some, it is important to understand different types of debt.

Some experts talk about the concept of good debt and bad debt. While I don't fully agree with this, I will still discuss the general theory behind this classification as I think it is a great starting point. 

What is Good Debt?

In short good debt is something that will appreciate in value or act as an investment. This would be a house, an education or starting a business. The caution here is that depending on the market in which you bought your home, or how your business pans out, you may end up losing money instead of gaining any benefit. You should also consider how you will make a return on your education when you take out a loan for it;be wary of studying an obscure subject area with few job opportunities. 

What is Bad Debt?

Bad debt is known as consumer debt which is credit card debt, personal loans and car loans. These also spans line of credit or family loans to cover things that are not necessities. In general going into debt should not be a way to satisfy your desire for something new, saving should be the go to way.
This requires disconnecting from the modern idea that your needs should be instantly gratified.

Other Situations

You may find yourself having to go into debt to for emergency reasons. Such as a sudden illness, or an unfortunate series of events that leave you with your back against the wall financially. These situations are rare and usually come at intervals in your life. This does not discount the ability for you to have a very unlucky set of weeks.

General Rules of Thumb

1) Avoid all Debt like the Plague.

Do not except for an emergency, spend money you do not have on things that you don't really need. Refrain from using debt to inflate your quality of life, it will at some point catch up with you. Contentment and stress-free living hinges a lot on living with-in you means. 

2) If You are in Debt, Prioritize Getting Out of It

This one is straight forward. If you find you have a lot of consumer debt, you should be paying as much of your disposable income towards this debt as you can manage. Tackle your debts one by one, being consistent with your payments. Care should be taken not to put so much money towards your debt that you end up going into more debt to meet your basic needs.

3) Save 

Even if you are deep in debt, it is necessary to have some savings which you can utilize in emergencies. If you can save at least five hundred dollars as a cushion, this will give you more financial security. Ideally you should have at least a month's worth of expenses saved.

4) Design your Ideal Life

One way to stay motivated while paying off debt, but also to avoid taking on debt recklessly, is to have a clear picture of the life you are trying to build. When you have a destination in mind, you will be able to decide if you really need to buying a new coat, if you should send that money to debt or save it. Making big decisions like buying a home, paying for a child's education or buying a vehicle, should not be made without weighing not only your current needs but what you want for you future.

I will continue to speak on the topic of debt in upcoming posts, focusing on having a good relationship with your debt and staying motivated while paying down your debt. Feel free to leave a comment, if you have a specific question you want answers about debt and I will answer it in my next post.

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