How to manage debt

Debt can be a positive or a negative factor in your finances – managing it effectively forms an important part of your overall financial health.

While it is difficult to live completely debt-free in the current economic climate, putting plans in place to effectively manage your debt can alleviate a significant part of the associated pressures.

Secured versus unsecured debt

Secured debt differs from unsecured debt in that it is backed by some form of guarantee, generally an asset that the borrower offers as collateral to the lender. The lender has the legal right to seize the asset in order to recoup its losses should the borrower default on the repayment agreement. Secured debt normally incorporates longer-term loans such as home loans and vehicle finance.

Unsecured debt, on the other hand, means that the lender has no safeguard against defaults and therefore it comes at a premium in the form of higher interest rates and less favourable repayment terms. The makeup of your total debt is a determining factor in your specific debt reduction or elimination plan.

Credit score

Your credit score is an indication of your ability to manage your debt and pay your bills. It is essential to manage your credit score throughout your lifetime, as it has an impact on your ability to secure financing, as well as the repayment terms and interest rates applicable. Employers also usually check the credit scores of potential employees in order to determine how suitable they are for the position they are applying for. It is important to keep in mind that it takes time to build up a credit history, generally around six years, so it is advisable for new entrants to the job market to start early with at least one line of credit.

Aspects that negatively influence your credit score includes the nature of your debt, late payments, failure to pay and having too many unused lines of open credit. Having excessive debt will influence your debt-to-income ratio, which in turn will affect your ability to obtain additional finance.

Nature of your debt

Positive debt generally encompasses debt incurred to achieve longer-term goals and includes student loans and home and vehicle financing. These types of debt are incurred to improve your net asset position and your ability to earn an income.

Borrowing that exceeds your current financial means, as well as unsecured debt such as credit card debt and retail store accounts that are used to cover lifestyle expenses, can be viewed as negative debt. If find yourself in the position that you are using unsecured debt to cover your living expenses and pay for luxuries, you need to adjust your monthly expenses so that you are living within your means. If you fail to do so, interest rate increases, or unforeseen setbacks, could have serious consequences on your financial health.

Negative effects of excessive debt

Having excessive debt can have a significant detrimental impact on your physical and mental well-being. Struggling to settle your monthly bills can lead to depression and anxiety, which in turn can lead to strained inter-personal relationships and physical health issues such as tension headaches, ulcers, high blood pressure and various addictions. Anxiety over debt can also cause you to make irrational and emotional financial decisions that can exacerbate your financial difficulties.

Debt management strategies

The two most popular strategies for paying off debt are the debt snowball and the debt avalanche methods.

Debt snowball

With this method, you start by paying off your smallest debt first while still making the minimum payments on your other debts. Then you move on to the next-smallest debt. Paying off each debt in turn will give you a sense of momentum that builds over time.

Debt avalanche

With this method, you start by paying off the highest-interest debt first while making minimum payments on all other debts. Then you start paying off the next highest-interest debt. You will pay less interest over time by eliminating the higher interest rate debts first, and each debt paid off will leave you with more money each month to settle the remaining debt faster.

While the debt avalanche strategy can help you save money on interest, you may prefer the feeling of accomplishment you get from the debt snowball method when you pay off smaller debts first.

Another option is to consolidate your debt. Debt consolidation refers to taking out a new loan to pay off other existing loans or credit cards. By combining multiple debts into a single, larger loan, you may be able to obtain more favourable payment terms, such as a lower interest rate, lower monthly instalments, or both.

Whatever method you choose, you will need to start by listing all your debt, the respective interest rates attached to each debt, and the minimum monthly payment due. A helpful tip is to find an online debt reduction calculator that can help you develop a comparative timeline using each of these strategies in order to obtain a clear picture of the way ahead.

Speak to your financial advisor for more information on debt management as it applies to your specific financial circumstances.

The information contained in this article is of a general nature and intended for information purposes only. It is neither to be construed as financial advice nor to be regarded as a definitive analysis of any financial, legal or other issue. Individuals must not rely on this information to make a financial or investment decision. Before making any decision, we recommend you consult your financial planner/adviser to take into account your particular investment objectives, financial situation and individual needs.