So getting out of debt is at the top of your financial wish-list for 2015. How are you going to do it?
- How can I sort out my spending?
Wouldn’t it be great if there was a magic formula that made debt melt away with very little effort? Or if someone took pity on you and paid your bills? Still hoping for that Lottery win?
Everyone has quick-fix fantasies. But if you’re waiting around to be rescued, you’re probably not doing the very thing that will make a difference: taking responsibility for your own financial situation. Working to pay off debt makes us feel more capable of handling our money. It also actively helps us transform the patterns of thinking and behaviour that got us into debt in the first place. So we not only get out of debt, we stay out.
Changing behaviour is key, according to Wally David, Melbourne financial planner and author of thesmartmoney.com.au. “If you don’t change those behaviours you won’t actually solve the underlying problem.”
Whereas an unexpected emergency may have led you down the debt rabbit hole, for most of us it’s simply a case of spending more than we earn, particularly at Christmas, as many of us are discovering as we receive our credit card statements.
In the past two months Marina McHutchison and her husband Perter have paid off about $10,000 from their accumulated debts of more than $100,000.
Often we know we’re spending money we don’t have, but we choose to ignore it. We decide to buy now and worry later.
It’s not just young people or low-income earners who get caught in the debt trap. Dominique Bergel-Grant, founder of and financial planner with Leapfrog Financial, says one client racked up $250,000 in credit card debt after leaving a corporate job to become a self-employed consultant. “He was still living his life as if he was earning $250,000 a year so it didn’t take that many years for him to accumulate that level of debt.”
Sunshine Coast resident Marina McHutchison and her husband Peter accumulated more than $100,000 in debt after a property investment went sour and she suffered a back injury.
Wally David says increasingly people in their 50s and 60s are approaching retirement with a residual home loan, the product of being too free and easy with their equity.
He puts Australians’ escalating debt levels down to the availability of credit. “It’s never been easier to buy things that you don’t have the money for,” he says. We’ve also become used to living in the Lucky Country, where we’ve managed to sidestep a major economic downturn for a couple of decades.
“If you’ve never experienced a downturn or adversity then you assume that the good times will roll on.”
So is there anything wrong with a credit card-funded lifestyle?
Yes, says Bergel-Grant, adding it often comes back to bite people when their circumstances change.
“We all think that we can work and generate an income forever but if we are either forced through redundancy to stop working or we want to stop working because of retirement or health reasons realistically you are left in a fairly drastic situation.”
It also creates a roadblock when people want to buy their first home.
So how do you make getting out of debt more than wishful thinking?
The beginning of financial transformation starts with arresting the denial. Look at what you are spending, when and why. “Sometimes the cause of debt is something as serious as gambling or alcoholic problems or it may be intermittent work,” says Bergel-Grant. “Self-employed people tend to fall into high credit card debt when they try to fund their business cash flow using a credit card.”
Get clear about money coming in and how you are using it, says David. A budget or spending plan is essentially working out how to use your money so it supports your priorities and values. It will help you to see how you can free up more money to pay off your debts.
Select a strategy
Some people swear by the Snowball method for paying off multiple debts; others favour the Avalanche method. Debt consolidation has its fans too. So how do you decide?
- The Avalanche method This is where you tackle the debt with the highest interest rate first. Why? “Debts with a higher interest rate grow faster because of the effect of compounding interest,” explains David. “So paying these debts first should save you money in the long-run.”
- The Snowball method This starts with paying off the smallest debt first, then tackling larger and larger ones. Why? “If someone has got a lot of smaller debts that can lead to them feeling overwhelmed especially when they are dealing with several companies and lenders,” says David. Paying off one debt quickly creates a sense of positive momentum and encourages you to keep going.
Financial planner Peter Horsfield is a big fan of the Snowball method. He gives the example of a couple who had multiple debts ranging from $1300 on a credit card to $100,000 on a home loan. He asked them to direct 10 per cent of their gross income, or $750, towards debt repayment, starting with the smallest debt. When that debt was paid off the trick was to add the amount they were saving ($300 per month) to the $750 and direct that towards paying off the next debt. “You lather, rinse and repeat until all your debts are paid off,” he says.
The Snowball and Avalanche methods can overlap. “Often the smaller debts come from credit cards and store cards that have the higher rates of interest,” says David.
At this time of year many financial institutions present balance transfer offers or personal loans as a way out of debt. A balance transfer offer – such as zero per cent for 24 months – stops interest accumulating on your credit cards giving you space to make inroads into debt repayment. Likewise, consolidating debts into a personal loan or home loan can reduce the interest being paid.
Bergel-Grant favours the disciplined approach of consolidating into a personal loan. “Then they’ve got a set debt, everything’s in the one place. They have to make a minimum repayment every month and because they don’t have the option to pull out the cash they are actually paying off the principal.”
She then advises clients to cancel and chop up their cards. With the Snowball and Avalanche methods card facilities stay open, which can make it tempting to keep using them.
Although mortgage rates are lower than credit card or personal loan rates, David says the total interest bill can end up higher if someone takes 20 years to pay off a debt instead of five.
He cautions people to be wary of balance transfer offers if they’ve tried that strategy before only to end up with larger debts. “It’s not to say that you shouldn’t attempt it again. It’s just that you probably need stronger parameters around it. Your credit cards need to be cut up and cancelled altogether and maybe you need someone to help keep you in check and monitor your progress.”
Get set for success
Reduce wriggle room by cancelling and cutting up credit cards and don’t wait to see what’s left in your bank account at the end of the pay cycle. Westpac spokesperson Jessica Power suggests setting up an automatic transfer to your debt, ideally of more than the minimum repayment.
Work out your target
Your target is the sum of your debts, right? Not necessarily. As McHutchison is finding having a goal beyond your debts can put a more positive spin on a decision to be rid of debt. “Where I’ve seen it work really well is for people who are first homebuyers,” says Bergel-Grant. “They know that they are never going to get their foot on the property ladder until they get rid of this debt and build up some savings.”
If getting free of debt is going to take years, be sure to reward yourself along the way. Bergel-Grant suggests planning and budgeting for rewards when you reach certain milestones: “If you just feel like you’re restricting yourself you’ll simply give up. So I think it’s OK if you set yourself milestones where you may allow yourself a little shopping spree.”
Another alternative is to include some money for fun in your spending plan. And don’t beat yourself up if you fall off the wagon occasionally.
Call in the support crew
Sticking to a get-out-of-debt plan is easier if someone holds you accountable. Get the support of a financial planner, a friend or family member. Action Plan
- Understand how you got into debt
- Set a spending plan
- Select a debt repayment strategy
- Have a goal beyond debt repayment
- Automate success and build in rewards
- Get support
Attacking the mountain in small steps
Marina McHutchison and her husband Peter are making great headway with their plan to get debt-free and buy a house. In the past two months they’ve paid off about $10,000 from their accumulated debts of more than $100,000.
They are attacking their highest rate card first and working towards consolidating debts into a lower rate loan.
The Sunshine Coast resident says doing a 21-day Money Intensive program with Brisbane facilitator Anne Aleckson not only helped with practical financial strategies and accountability, it shifted some of her habits of thinking, from one of lack to appreciating what she has.
She now feels less anxious about money and is clear about how she wants to be spending both on an everyday basis and in the long-term.
It all makes it easier to stick to spending boundaries. She’s cut the family food bill (they have four children aged nine to 17) from $450 a week to about $250 and is saving an emergency fund.
On top of that she switched to a prepaid mobile; secured a 10 per cent cut in their insurance premiums; every second beauty treatment she does at home and they use their small car rather than their 4WD where possible; and ask their teenage children and friends to cover the cost of their trips.
To McHutchison getting rid of debt is now seen as a more positive stepping stone along the way to home ownership. Read on