Financing your car purchase the smart way

30 May, 2016

If you’re planning on buying a car, chances are you’re looking at your options for financing your car purchase. It’s one of the more expensive purchases in life, and with the high price tag comes a higher risk of losing money if you rush into things.

To begin with, cars can hardly be regarded as an investment. When you factor in running costs, depreciation, rego, insurance, etc. you can see that they really are a drain on your finances. A poorly-researched payment option can just be another thing that adds to the ongoing costs of your car. That said, for many of us a car is a necessity for getting to work and getting around, so it’s a case of minimising the damage it does to our wallet.

Let’s take a look at the main finance options available when buying a car and the things you should be aware of to avoid paying over the odds (for your finance, that is, not the car – that part is up to you).

 

Financing your car purchase with a loan

As with personal loans, it can be worth looking beyond the main lenders to get a good deal when financing your car purchase. Some credit unions will even help with the process of buying a car, which you might appreciate if you feel a bit out of your depth doing it for the first time.

If you’re buying a new car, you’ll be able to use the vehicle as security for the debt, which helps to keep the rate down but does mean the lender can take possession of the car if you don’t keep up with your loan repayments. For second-hand purchases they may not accept the vehicle as security because it’s harder to sell on if it gets repossessed. If that’s the case, you’ll need an unsecured personal loan.

Lenders will often offer discounted rates on cars with eco-friendly features and a high ANCAP (Australasian New Car Assessment Program) safety rating. You can check safety scores at ancap.com.au or visit greenvehicleguide.com.au for greenhouse ratings. If you find a good deal on a car with both of these scores, it could be a wise choice since you’ll be saving money on your finance as well as running costs.

After shopping around for a loan and finding one that you’re happy with, see if you can apply for pre-approval from the lender (not all offer this option). There are two benefits to having pre-approval before you hit the dealership: firstly, it’ll put you in a stronger bargaining position, and secondly, it should reduce the temptation of expensive dealer finance.

 

What to watch for with dealer finance

Dealers want to make it as easy as possible for you to walk into the showroom empty-handed and leave a few hours later jangling your new keys. That’s why they make their financing options so seductive and convenient, providing an on-the-spot decision before common sense gets the better of you.

That’s not to say they’re all bad – there are some competitive deals to be had out there – but you have to choose your dealer and time your purchase perfectly if you’re going to come out on top.

After choosing your vehicle at the dealership, they’ll take you through a credit application. This is assessed either by a separate financing division or by a third party finance company, and you’ll receive a decision almost immediately.

To calculate your interest rate, the dealer will look at a number of factors such as your credit record (any problems in the past might push your rate up) and how old the vehicle is (you’ll usually get a better rate on a new car). You might also be able to secure a better deal if the car will be used for business and you can provide an ABN (Australian Business Number).

When presenting you with a loan offer, the dealer is unlikely to focus on the rate, term and overall cost of the product and will instead hit you with lines like “You only need to pay back $85 a week!”

You, of course, will not fall for this tactic. As a consumer, you need to know what the fees are for the loan, what interest rate you’ll be charged, and what the loan term is (how long you’ll be paying it back for). $85 per week might represent quite a good deal for the car you’re buying if it’s spread over a three year term, but if it turns out to be five years, it’s a different matter.

Once you have this information you can compare it to the personal loans you’ve researched and see how it stacks up.

If the dealer seems at all reluctant to provide you with the details you’re requesting, say goodbye to him and the car and find another one – this is a sure sign that he’s trying to rip you off with high rates or fees, or both.

Be wary of any extras you’re offered at this stage, too. Tinted windows and an extended warranty might only add a couple of dollars a week to your loan repayments, but look at how much they’re costing over the full term of the loan – probably a lot more than you’re really prepared to pay. If there is something you really want to add, consider paying for it in cash so it won’t be subject to any interest.

Found this article useful? Here are 8 more tips for getting the best deal when financing your car purchase.

 

To recap:

  • The two main options for financing your car purchase are a personal loan and dealer finance
  • A personal loan may offer better rates and lets you do your research beforehand
  • Brand new cars attract a lower rate, and so may energy-efficient ones
  • Get pre-approval from your lender if possible
  • Some finance deals can be competitive but make sure you’re clear on the rate, fees and loan term
  • If you want any optional extras, try to pay in cash rather than adding them to your finance deal otherwise you’ll be paying tons of interest on them

 

finance a big purchase

Ways to finance a big purchase the smart way

27 May, 2016

No matter how hard you try to stick to the ‘save now, buy later’ mantra, there will be occasions in life when you have to finance a big purchase by borrowing money.

Whether you’re planning a wedding, furnishing your new home, updating your computer or preparing for the arrival of a baby, the golden rule is to shop around for the best deal available. Once you’re happy that you’ve found it, pay in cash wherever possible – this may even secure you a greater discount on the item and you won’t have to deal with the stress of ongoing repayments and the extra cost of interest charges.

But if you don’t have the spare hundreds or thousands of dollars lying around that you need to complete the purchase, what are your options? Don’t automatically reach for your credit card, because although it may feel like the simplest way to pay, it’s also potentially one of the most expensive and can lead to spiralling debt if not carefully managed. Here are some of the other purchase options, and potential pitfalls to be aware of before you rush into any of them:

 

Consider the old-fashioned option

It might not feel very cool to ask your friend if you can come to their place to watch the match because you’re paying for your new TV by lay-by, but it can be a savvy payment option. First, you’re not paying any interest, and the extra charges (if the retailer charges any at all) are minimal. Second, you can pay for the item at a pace that suits you.

The obvious downside is that you don’t get your item until you’ve finished paying for it, which can be tough in today’s culture of instant gratification. Most stores are quite strict with lay-by periods, and for very expensive purchases this may not give you long enough to complete the payments. You may also find that some stores no longer offer lay-by as a payment option, because so many people have credit cards these days and with lay-by the retailer has the hassle and cost of storing the item until you collect it.

 

Know what you’re getting into with store finance

Many stores selling big-ticket items like electricals and furniture will entice you with ‘interest-free’ and ‘pay nothing for 3 years’ deals. You’ve no doubt seen them all over the place. Just remember, they’re not offering you a ‘buy now, pay later’ option out of the goodness of their hearts; this is just another way for them to fatten their profits.

If you’re not very careful to check what you’re signing up to, you can end up being hit with fees, charges and restrictions that saddle you with unexpected debt.

More often than not, these finance deals are provided through a third-party finance company which will send you a statement each month with a suggested minimum repayment. However, these payments are not designed to help you clear the debt before the interest-free period is over, and once it is up, your balance could be subject to rates as high as 30%. In addition, the credit provider has no obligation to remind you of when the interest-free period expires; it’s up to you to keep tabs on that.

IF you can work out your own payment plan and IF you’re disciplined enough to stick to it, you might just have got yourself a good interest-free credit deal. Oh but wait…

Have you factored in the fees that usually accompany these kinds of deals? There might be an arrangement fee, monthly account fees, and late payment fees if you don’t keep up. Even if you’re not being charged interest, these fees can make a purchase a whole lot more expensive so check them carefully.

And there’s more… some interest-free credit contracts come with the condition that you CAN’T PAY MORE THAN THE MONTHLY MINIMUM PAYMENT. This will completely scupper your chances of clearing your debt on your own terms and without accruing interest, so, again, check and double-check the fine print.

Bear in mind that the shop assistant you’re dealing with isn’t a finance expert, so don’t rely on them to answer any questions you have about the deal in question. Also remember that many of these behind-the-scenes finance companies don’t have much of a public image to uphold so won’t think twice about resorting to aggressive debt recovery tactics if you fall behind on payments. Mainstream banks, on the other hand, may be more flexible in revising your payment plan if you’re struggling.

One final word of warning about interest-free deals. The long timespans they offer may make the repayments super affordable, but do you really want to still be paying for your baby’s cot when she’s already grown out of it? There’s every chance your washing machine could break after 4 years and you’ll be stuck paying for it for a whole year beyond its lifespan. What if your relationship ends but you’ve still got 3 more years of paying for ‘our’ bed ahead of you? You need to factor in the element of the unknown, and the longer your payment term, the greater the chances of something happening to derail your current lifestyle.

If you do opt for a store deal like this to finance a big purchase, make sure it’s properly considered – not an impulse buy – and you’re confident you can make the most of the interest-free period on offer by carefully timing your repayments.

 

Store credit card? No thanks.

Do you think the retailer is doing you a favour by offering you a ‘complimentary’ store credit card with your purchase? Think again. This card will encourage you to shop at their store only – meaning you miss out on better deals that may be available elsewhere – and they tend to come with uncompetitive interest rates.

Better to turn it down or, if you find you’ve inadvertently signed up for one, cancel it straight away.

 

What about a personal loan?

Personal loans can be a pretty good choice if you need to take on debt to finance a big purchase. Although the headline rates may not be as good as in-store finance deals, they offer a fixed repayment schedule and a clear up-front picture of the total amount repayable so you can be fully informed about the cost of borrowing.

The time taken to arrange a loan, even if it’s only a day or two, will also give you a bit of a cooling-off period to make sure you’re really committed to purchasing the item in the first place.

When searching for a loan, do choose one with a provider that will let you make additional payments so you can reduce the term of the loan. Even paying back a small amount extra each month can make quite a difference to the interest you pay in the end, and if you have some extra cash in the future you might want the flexibility to repay your loan early.

As with any financial product, make sure you shop around first to be confident of securing the best deal available. Comparison sites  make it easy to see what’s available on the market and will help you take into account not just the interest rate but any applicable fees. With some providers charging as much as $200 or $300 in application fees on top of ongoing administration fees, it really pays to work out the overall cost of the product – this is called the ‘comparison rate’.

Be prepared to look beyond the mainstream banks, as lenders like credit unions and building societies have traditionally been more competitive with personal loans. Online banking means you don’t have to worry about choosing an institution with a nearby branch, and there are increasing numbers of online-only banks to choose from.

Next, consider the term (length) of the loan. Choosing a shorter term will mean you spend less on interest but have to pay more back each month. The table below shows what a drastic difference a couple of years can make to the total amount you repay.

 

Cost of borrowing $10000 at 13% over different terms

 

  3-year term 5-year term 7-year term
Monthly repayment $337 $228 $182
Total amount repaid $12 130 $13 652 $15 281
Overall interest cost charge $2130 $3652 $5281

 

The option to secure your loan

One way to reduce the cost of your loan is to provide some kind of security or collateral. The risk of loss to the lender is reduced because if you default on your payments they can claim possession of the asset offered as security.

Different lenders will have different rules when it comes to accepting securities. Some may accept a cash term deposit, others will require a percentage of equity in a property, and if you’re using the loan for a car they may take the car itself as security.

That’s not to say that if you pay the higher rates for an unsecured loan you can walk away from it any time you want. The lender may pursue you for the debt or hand the matter over to a debt recovery agency, and that’s when you get two burly guys dressed in black knocking on your door. If you owe more than $5,000 the agency can apply to have you declared bankrupt so this is not a decision to be made lightly.

So, a personal loan can be a good choice to provide you with a clear and structured repayment plan at a reasonable rate. Just be careful about how much you borrow because if you fall behind it could affect your credit record for years to come.

 

Access your home equity

If you already own a home and have built up some equity in it, consider using your mortgage to access extra low-rate funds to finance a big purchase.

If you have previously made extra payments into your mortgage you may be able to access this money via redraw. This means you don’t have to extend your loan, but it also comes with a redraw fee and cancels out some of that progress you made in paying back extra in the first place.

You also have the option to extend your home loan, meaning you access the additional funds at mortgage rates, which are usually the lowest on the market.

Although this option offers low rates, you need to be prepared to pay back more than the minimum amount each month otherwise the interest charges could add up to a lot more than you realise over the long term of the loan.

The table below shows how a long-term payment option like a mortgage can almost double the cost of whatever you’re buying. Say you borrow $7,000 for a new kitchen refit. It you tack that amount onto a $300,000 home loan charging 7% interest with 20 years remaining, it will add an additional $6026 to the overall interest you pay. That’s a pretty expensive kitchen!

In contrast, if you took out that same amount on a personal loan charging 13% over three years, you’d pay just $1491 in interest because the term is so much shorter. Of course, you’d have to pay back a much larger amount each month to make it work.

Perhaps the worst option is to pay by credit card and then only make the minimum payments. This would add an additional $10,256 to the cost of your kitchen and take an unbelievable 27.5 years to pay back.

 

Comparison of credit costs

 

Home loan Personal loan Credit card
Purchase price $7000 $7000 $7000
Interest rate 7% 13% 15%
Time taken to pay off purchase, making minimum repayments 20 years 3 years 27.5 years
Interest cost $6026 $1491 $10 256
Total cost $13 026 $8491 $17 256

 

If you do decide to finance a big purchase through your mortgage, you can help yourself keep up with the extra repayments by setting up a direct debit to automatically make the payment each month. Check your budget to see how much you can afford to set aside, and how long it will therefore take for you to cover the cost of the additional debt plus interest. If you think you’ll struggle to stick to these regular payments, a personal loan could be a better option for you.

One big-ticket item that’s noticeably absent from this article is a car – that’s because we’ve covered the process of financing car purchases in a separate article – take a look now if you’re interested.

 

Things to remember before you finance a big purchase:

  • Don’t automatically use your credit card to finance a big purchase – the interest rates can be crippling
  • Consider lay-by if the payment terms work for you
  • Read the fine print VERY CAREFULLY before signing up for an in-store ‘interest-free’ deal. Take into account any extra fees and make sure you have the option to make extra repayments during the interest-free period
  • Decide whether you really want to still be paying for your purchase several years down the line
  • Say ‘no’ to store credit cards, or cancel them immediately
  • Shopping around for a competitive personal loan provides a transparent finance option with regular repayments and a fixed term. Again, consider the fees and opt for the shortest term you can manage to minimise interest costs
  • If you have a home, consider tapping into your mortgage but be prepared to make extra repayments otherwise the interest charges will skyrocket

 

lenders mortgage insurance

Lenders mortgage insurance – making switching difficult

25 May, 2016

If you’re considering refinancing your home, whether it’s to consolidate your debt, to access equity or to get a better deal, you need to properly assess the costs and benefits involved. Lenders mortgage insurance can, unfortunately, eat into any potential savings you get from switching.

 

Check your equity

One of the things you need to know early on in the process is your home equity – your home’s current market value minus any money you still owe on it. You may be able to get this estimated by a local real estate agent free of charge. 

The reason it’s important to know your home equity when refinancing is because if you don’t have at least 20% equity, your new lender will require you to pay lenders mortgage insurance (LMI).

That means if your home is worth $500,000, you should be able to borrow up to $400,000 without needing LMI. Beyond this threshold, you’ll be subject to LMI premiums which can reach five figures, effectively wiping out any savings you’d make from refinancing.

 

What is Lenders Mortgage Insurance?

Lenders mortgage insurance (LMI) is designed to protect the lender when they enter the higher-risk scenario of lending over 80% of the home’s value. If you fail to keep up repayments and there’s a shortfall when it comes to selling the house on, they’ve covered their backs. Despite you having to foot the bill for LMI, it won’t do anything to help you if you fall into difficulties.

Your lender may well play down the cost of LMI by offering the option of capitalising your premiums. This means you add the cost of the insurance to your loan balance and pay it back along with your mortgage. Although this may seem more affordable, you’ll actually end up paying a lot more in the long run because the LMI cost will then be subject to interest.

If you paid LMI upon the initial purchase of your home, it may seem unfair that you’re being asked to pay it again. Unfortunately it can’t be transferred between lenders so there is no way around it if you’re borrowing 80% or more of the property’s value with a new lender.

This cost can be the biggest hurdle for many homeowners who are trying to switch to a more competitive mortgage deal.

 

How much is LMI?

To give an idea of the kind of money we’re talking about, the table below shows an estimate of the premiums you’d be hit with for a loan on a property worth $400,000, with varying levels of equity. If you only hold 5% equity ($20,000), the LMI premium could be over $12,000. You can see how it would be tough to recover this kind of money from just switching to a more competitive rate.

If you’d like to get an idea of what the LMI premium could be for your own situation, make sure you’re sitting down and then visit LMI insurer Genworth’s premium calculator at genworth.com.au.

 

Indicative LMI when refinancing a home worth $400000

 

Property value $400 000 $400 000 $400 000 $400 000
Required loan value $380 000 $360 000 $320 000 $300 000
Home equity amount $20 000 $40 000 $80 000 $100 000
Equity as percentage of home value 5% 10% 20% 25%
Potential LMI cost $12 426 $6408 $1095 Nil

 

In short:

  • If you’re refinancing but have equity of less than 20%, you’ll have to pay lenders mortgage insurance (LMI)
  • The cost of LMI can wipe out any potential savings from switching to a better deal, so calculate the benefits carefully
  • Don’t be tempted to add LMI costs to your loan balance as the interest charges will make it even more expensive
  • LMI can’t be transferred between lenders

 

optimising home loan

Are you getting the most out of your home loan?

23 May, 2016

A home loan is the kind of debt we can refer to as ‘happily necessary’; that is, you’re using it to purchase a major asset which should grow in value as you pay back the loan. The idea is that you retire debt-free and with a nice amount of equity value in your home.

The thing is, a quarter of a century is a long time to be paying back a loan, and your lender won’t stop adding interest until you’ve paid back every cent. The sheer size of the debt combined with the extended term means you can easily end up repaying more than double the amount you originally borrowed.

Many people choose to buy rather than rent because they see renting as ‘dead’ money. But if $250 of the $500 you’re paying back on your home loan each week is going straight into the lender’s pocket, shouldn’t that also be considered ‘dead’ money?

Your mortgage is draining your bank balance of cash that could be going towards much better things, so what are you going to do about it?

Before we dig down deeper into some ways you can optimise your mortgage and pay off that debt sooner, just remember that a home loan offers the most competitive rates around and is linked to your home as security. If you have other high-rate debts like a personal loan or credit card, you’ll save more money in the long run by paying those back first.

 

Repay extra when you can

Possibly the most straightforward way to save yourself money in interest charges and become debt-free sooner is to make extra repayments towards your loan.

Mortgage interest is calculated daily, and you’ll find that for the first few years the payments you make are barely covering the interest charges. If you make an extra payment it comes straight off the loan principal (the amount outstanding) so you reduce your interest costs immediately – a double benefit.

If you can’t see how paying back a little bit here and there is going to help, remember that sticking to the minimum repayments could mean you end up paying more in interest than your home was originally worth.

Say, for example, you take out a 25 year loan worth $350,000 with a rate of 7%. Your monthly repayments will be around $2,474 and over the entire term you’ll pay back just over $742,000. That means you’ve paid more than $392,000 in interest when you only borrowed $350,000 in the first place.

Just believe us that any extra amount you can pay back will start to reduce that shocking number. Well you don’t need to believe us actually, as we’ve done the maths for you.

The table below shows the effect of paying back just $1 extra per day on that $350,000 loan – you would save almost $15,000 in interest and be debt-free nearly a year sooner. If you made it $10 a day you’d save over $100,000 and clear the debt six years sooner.

 

Possible interest savings with extra repayments

 

Loan principal: $350 000

Term: 25 years Interest rate: 7% p.a.

Pay $1 extra per day Pay $2 extra per day Pay $5 extra per day Pay $10 extra per day
Potential interest saving $14 836 $28 324 $62 967 $106 940
Reduction in loan term 10 months 18 months 3.5 years 6  years

 

Careful budgeting will help you set this extra money aside, and it really is worth the sacrifice when you look at the potential savings.

If you’re already in a financial squeeze, put any lump-sum payments like your annual tax refund towards paying off your loan. If you don’t let the money linger in your account for too long, you won’t be able to miss it. If you get a pay rise at work, channel the increase in your pay packet straight into your mortgage repayments and you’ll never notice the difference.

 

Re-work your home loan payment schedule

This works really well if you get paid fortnightly or weekly. You normally make 12 payments each year, on a monthly basis. But if you divide the year into fortnights, there are 26. If you set aside half of your monthly repayment amount every fortnight, you’ll actually end up making 13 repayments, but you’ll hardly notice the extra leaving your account (especially if you time it for just after you get paid). The same applies to a weekly payment; just make it a quarter of the value of the monthly amount.

The only problem is that not every lender will let you make this many small payments in place of one monthly one, but it’s worth asking anyway because it’s a good way to trick yourself into saving a bit more.

 

Save tax-free with redraw facilities

Perhaps you’re convinced of the benefits of extra repayments but worried that you might need some of that extra money back one day. Well, it’s redraw facilities to the rescue! If your home loan has a redraw facility, you have the option to take back any of the extra money you’ve already paid in. You should view this as a last resort though, because doing it too often will undo all the hard work you put in to making those repayments in the first place, and you’ll probably be charged a redraw fee for each transaction.

If you can get your head around it, you can actually view your redraw facility as a way of saving tax-free instead of ploughing money into a savings account where any interest earned is taxable.

Just think about it: personal savings rates are generally pretty low, and while that money is earning (taxable) interest of maybe 2-3%, your mortgage is accruing interest charges at a much higher rate. Better to put any extra cash towards paying off your mortgage and avoiding those higher interest charges. The ‘return’ is not going to just appear in your bank account one day, but comes in the form of a steady reduction in the amount of interest you owe on your mortgage – and the tax man has no claim to that!

Do make sure your mortgage does actually have a redraw facility which you can use in emergencies before embarking on this route.

 

Use a tax-efficient mortgage offset

If you’re not too comfortable with the above scenario, another option is a ‘mortgage offset’. This is similar to a redraw facility but includes a savings account linked directly to your loan, so any money you pay in is kept separate.

You won’t earn any interest on the savings in that account, but the balance is used to offset your home loan when calculating interest.

So, say your mortgage balance is $400,000 and you have $20,000 in the savings account, you’ll only be charged interest on $380,000.

Again, your money is working to reduce the amount of interest you have to pay (not taxable) rather than earning interest that is taxable.

Mortgage offset accounts often come with a slightly higher rate than a standard home loan, so will be of most benefit if you can maintain a reasonable level of savings in the linked account.

 

Refinance – but not without difficulty

While you’re busy making these extra payments and using savings to whittle down your home loan debt, make sure you keep an eye on the rate your lender is charging you. They have a sneaky habit of pushing it up now and again, hoping you won’t pay much attention to the letter they send to notify you of the increase.

It’s important to try and maintain a competitive rate because even a few percentage points difference can have a huge impact on the overall cost of your loan. Check the market now and again to see how your loan stacks up against the other products available.

Taking out a new loan with a new lender so you can pay back your old loan is called ‘refinancing’. You can read more about that here. Mortgage brokers and lenders would have you believe this is a simple process which just involves filling out a few forms, getting your application approved, and transferring the balance. Unfortunately, this isn’t always the case and you can end up wasting a lot of time and money if you don’t do enough planning and research.

One of the most expensive obstacles you’re likely to face is lenders mortgage insurance, which applies if your deposit is below 20%.

If your reason for refinancing is simply to get a lower rate, first try approaching your current lender to ask if they can switch you to a loan with a more competitive rate. If they’re not budging, try showing them an offer in writing from another lender. You’re a valuable source of income from them and they might be willing to drop your rate if it means keeping you as a customer.

 

In short: ways to optimise your home loan

  • Making extra repayments will cut the amount of interest you pay immediately so it’s really worth making the effort to do this, whether it’s regular payments or occasional lump sums
  • If you’re paid weekly or fortnightly, see if you can change your monthly payments to match when you get paid – but increase the amount slightly at the same time
  • Make use of a redraw facility or mortgage offset to effectively achieve tax-free savings. You’ll still be able to access the extra money repaid if you need it
  • Refinancing can be more complicated and expensive than it seems; a better option is to ask your current lender for a rate reduction, backed up with a more competitive offer from another lender if necessary

 

debt-free world

Is it possible to live debt-free in today’s world?

18 May, 2016

We all agree with the basic financial principle that being in debt is bad and having savings is good, right? So does that mean that we should all be aiming to completely wipe out our personal debt? Is living debt-free even possible – or practical – in Australia today where it’s almost expected that everyone has some level of debt?

So many questions… let’s break this down.

 

Can debt be helpful?

There is something to be said for building up a good credit record by making regular loan repayments or having a credit card that you pay in full and on time every month. It’ll be harder to get a mortgage if the bank can’t see any kind of history to show that you’re a responsible borrower.

Additionally, you could have trouble booking flights, hotels and concert tickets with certain companies if you’re not paying by credit card.

 

What types of debt are acceptable?

Go back a couple of generations and you’ll probably encounter the mindset ‘if you can’t pay for it in full, don’t buy it’, the only exception being a house. Today, more than ever, going in to debt to buy a home is unavoidable (just avoid interest-only loans). It’s probably ok to add a car to that list as well, but with both purchases, only commit to repayments you can afford. If that means going for a second-hand car instead of the newest model with all the optional extras, so be it.

For all other purchases, you’ll have to save for it before you buy it – if you want to live debt-free, that is.

Remember that even a mobile phone contract is a kind of debt, because you’re agreeing to pay a fixed amount for a period of time and there’s no way out of it, so be very careful about what you commit to.

Whatever debt you do take on, you should be aiming to clear it before you retire as it’ll become even harder to pay back once you’re living on a reduced retirement income.

 

How can I become debt-free?

If you and your credit card are currently inseparable, this is going to be a big lifestyle change. Credit cards are one of the easiest ways to rack up debt because they encourage you to spend today and worry about the consequences another time. If you can control your spending, make a few transactions by credit card each month and pay your bill in full and on time, solely for the sake of your credit record. If you know you’ll struggle with this, just cut up your cards and forget about them.

Then it’s time for a complete mindset change. Instead of the ‘have it now’ attitude shoved in our faces by retailers and the media, you’ll need to go for a more controlled, ‘work now, buy later’ approach. Take pleasure in knowing that your purchase is well-earned and 100% yours once you hand over your cash.

It might sound like hard work, but taking control of your finances in this way will put you in a much stronger position to deal with any unexpected expenses and could drastically improve your finances later in life.

 

So, remember:

  • A well-controlled credit card can be useful for a good credit record and certain purchases where payment methods are restricted
  • When you take out a loan for a house or car, make sure the repayments are affordable
  • Aim to be completely debt-free before you retire
  • Change your attitude to spending and only buy if you have the cash

 

types of debt

Which of these three types of debt do you have?

16 May, 2016

Very few of us will get through life without dealing with some kind of debt. But if you’re planning to reach that coveted ‘debt-free‘ status at some point in your life, it helps to understand the different types of debt that exist, as they aren’t all as bad as each other.

We’re all familiar with the basic principle of debt: you borrow money and pay it back with interest. But there are many intricacies which vary from one type of debt to another, including the purpose of the loan, the interest rate, and the conditions attached to it.

Some types of debt can be beneficial if managed properly; some are undesirable but unavoidable; and others are just plain ruinous. So let’s get a bit deeper into this so you can identify the kind of debt you hold and take steps to gain control over your finances.

 

‘Happily necessary debt

The clue is in the name – necessary, but in a good way because you’re purchasing an asset that will increase in value over time, thus returning a profit for you. Most of us will encounter this kind of debt in the form of a home loan.

Mortgages aren’t really that bad when you place them on the whole debt spectrum. They come with pretty low rates and usually extend for 25 years to give you manageable repayments. Imagine going to buy a TV on credit and asking for those repayment conditions!

When it comes to buying a home, unless you have parents who are as rich as they are generous, a mortgage is your only option anyway. It means you aren’t throwing money away on rent, and it is, in a way, forcing you to save, since the property you’re buying should appreciate as you’re repaying the loan.

But that doesn’t mean you should go racking up happily necessary debt willy-nilly; it still comes with a couple of conditions attached if you actually want to be able to pay it off.

Firstly, be realistic about how much debt you can manage. Don’t overextend yourself and find that dream house turns into a financial nightmare.

Secondly, make extra repayments whenever possible. Although interest rates on home loans are usually much lower than credit cards or personal loans, it’s scary how much you’re actually paying back over a quarter of a century.

Imagine you buy a home for $600,000 and pay a $100,000 deposit, leaving $500,000 to be covered by your mortgage. If you’ve got a standard rate of 6.5%, your total payments over 25 years will be over $1.1 million – that means you’re paying back more than double what you borrowed!

Just paying back a bit extra now and again when you can afford it could make a big difference over the term of the loan, meaning you’re debt-free sooner and have extra cash for the more important things in life.

Read more about how good debt can turn bad so you can take steps to avoid these problems.

 

‘Effective debt’

Moving on to a different type of debt we come to effective debt, which is used to buy an investment. It could be anything from shares to a new business to an investment property, but the idea is that you’ll make money on it over time. One important thing about this kind of debt is you can usually claim the interest charge as a tax deduction, so make sure you’re not missing out if this is a route you decide to go down.

It’s not just mortgages on residential or commercial investment properties that can be classed as effective debt. Margin loans used to buy shares or units in a managed investment fund and business loans for start-ups or buying existing companies also fall under this category.

Again, there are things to consider before jumping in to this kind of debt. The most important thing is that you have fully researched the asset you’re investing in and are confident it will deliver strong returns.

Pre-GFC, many Australians were investing in shares with very little knowledge of the market. After the market crash they found they were unable to keep up the repayments on the loans used to buy the shares, so they had to sell them at a loss.

So whatever kind of investment you’re considering, make sure you’re aware of the risks involved. Don’t just be enticed by the idea of extra tax deductions, because that won’t offset the losses you could make on a bad investment. Take your time, do your research, and invest in an asset that you’re confident will deliver long-term growth and healthy returns. Oh, and make sure the repayments are within your budget.

 

‘Disastrous debt’

The name definitely says it all with this one. We’re talking debt that comes with minimal effort and maximum interest rates. Hands up anyone who’s guilty of paying for a new pair of shoes, a night out, or even a holiday by credit card knowing full well that you won’t be able to pay your bill at the end of the month? If this sounds familiar, it’s a habit you seriously need to kick.

Credit card interest and high-rate personal loans are a huge drain on your finances, with the debt often lasting longer than the thing you bought in the first place. And if you stick to the minimum payments your card issuer gives you, you’ll never see the end of those bills (they set them that low for a reason, you know). You need to deal with this kind of debt immediately by making cuts to your regular spending so you can start to make a dent in your bills. Whatever you have left over each month should be used to repay your high-interest debt, and in the meantime you can avoid making the problem worse by leaving your card at home or, if you’re easily tempted, cutting it up. You can do it!

 

To recap on the three types of debt:

  • ‘Happily necessary’ mortgage debt is fine – just make sure the repayments are affordable
  • ‘Effective’ investment debt is fine too, as long as it’s thoroughly researched (and affordable)
  • ‘Disastrous’ credit card debt needs to be cut out of your life ASAP (possibly along with the card itself)

 

good debt pitfalls

Good debt can still come with these potential pitfalls

13 May, 2016

Although millions of people successfully pay back their mortgages and investment loans with no real problems at all, there are plenty of things that can happen along the way to trip you up. Even good debt that has been carefully thought through can quickly turn bad and get out of control.

 

What can go wrong with a home loan?

A home loan is generally considered good debt as it lets you secure a valuable asset. However, your mortgage can easily take a turn for the worse, whether through bad planning or pure bad luck. Here are some possible scenarios:

  • You pay over the odds for your home or choose an area that achieves hardly any capital growth
  • Interest rates rise and the repayments on your variable rate mortgage skyrocket
  • Illness or injury leads to unemployment, and without income protection insurance or savings you have no way to keep up repayments
  • You’re late paying a couple of times and this gets recorded on your credit file, held with credit reference agencies. Next time you apply for a loan this black mark against your name could make it harder to get accepted
  • Unable to repay your loan, you face having your home repossessed by the lender. You’re left with nothing to show for all the time and money you put into it.

 

What can go wrong with an investment loan?

It’s not just your mortgage that can land you in trouble. In fact, the world of investing comes with its own plethora of risks. Let’s look at a few examples:

  • You invest in a rental property but don’t realise until it’s too late that it requires some expensive repairs
  • There is low demand in the area you buy into and you end up with high vacancy rates or nightmare tenants
  • You mess up your tax return or try to over-claim your deductions and get hit with crippling penalties
  • You buy into or set up a small business which doesn’t achieve the cashflow needed to service your loan and ends up going under

 

Tips for keeping good debt good

We don’t mean to be all doom and gloom about debt but it’s important to be realistic and understand the potential pitfalls of whatever you’re getting into. You want your debt to be working for you, not against you, so remember these key points:

  • Research, research, and research some more before buying a property or investing in a business. Find out about the area, local market trends, and, for an investment, the demand for whatever you’re offering
  • Don’t push yourself to the limits with the monthly repayments you take on – allow some contingency for market changes
  • Seriously consider income protection insurance – life can take some unexpected turns
  • Know where you stand with the tax man and get professional help completing your taxes if you’re not confident doing it yourself
  • Try to build up a savings buffer to dip into in case of unexpected expenses

 

manage debt

Some simple dos and don’ts of debt to keep it under control

11 May, 2016

We’re keeping this one simple: some guidelines to help you get your debt under control and make sound financial choices in the future.

 

Dos of debt

  • Do pay by cash rather than credit card wherever possible – you might even get a discount from the retailer. For expensive purchases, consider using lay-by to avoid interest charges.
  • Do use financial comparison websites like ratecity.com.au, mozo.com.au and infochoice.com.au to shop around for the best deal to suit your needs with the lowest interest rates and charges.
  • Do take into account the security of your income and likely future household expenses before committing to debt of any kind.
  • Do prepare for the worst and get a decent life insurance policy – enough to repay your debt and let your family live comfortably if you were to die.
  • Do give some thought to income protection insurance; a safety net which will pay out up to 75% of your normal wage or salary if illness or injury puts you out of work. As a bonus, premiums can normally be claimed as a tax deduction.
  • Do clear your high-interest debt first. Credit cards and personal loans tend to rack up the charges more quickly than other kinds of debt, so pay them off as quickly as possible.
  • Do think carefully about when to use credit for everyday purchases. Look at the total cost including interest charges to see if it’s really worth it.

 

Don’ts of debt

  • Don’t take on so much debt that you put your financial wellbeing and your family’s welfare at risk.
  • Don’t rely on lenders to judge your ability to repay. Only you know your own circumstances, and all those offers to increase your credit limit are just a way for them to squeeze more money out of you.
  • Don’t ignore your loan or credit card statements. If you dread their arrival each month, it’s a sign that you’re spending too much and need to work to get your debt under control.
  • Don’t be tempted by an investment property just because of the tax deductions available. There’s a lot more to it than that, and healthy returns with strong potential for appreciation are what you should be focusing on.

 

interest charges snowball your debt

How interest charges can snowball your debt

09 May, 2016

Ask your grandparents their attitudes to personal debt and you’d probably find them rather cynical; in their day, you saved to buy things instead of borrowing money. And although this is a wonderful value to live by it is, frankly, unrealistic in today’s financial climate. But interest charges can make debt much harder to manage, so make sure you understand them fully.

 

The pros and cons of personal debt

Can you imagine having to save up for the full price of a house before you could live in it? It would no doubt leave most Australians renting for the majority, if not all, of their lives. If you need a car to get to work, how are you supposed to make the money to pay for it if you can’t first use it to get there? And how many startups and small business would have never made it off the ground if it weren’t for the loans their founders relied on?

While there are many ways in which personal debt is necessary and even helpful to individuals and the wider Australian economy, there are equally many ways in which debt can be damaging. High levels of personal debt mean that for many, the Australian dream of owning a home, living debt free, and having a big retirement fund is slipping further and further out of reach.

Living in debt can be a great cause of stress and unhappiness, and the effects can spread beyond the individual to their families and relationships as well.

And it’s not just low-income earners who struggle with problem debt. Studies have shown that around one in ten people who seek help with debt from a financial counsellor earn more than $60,000 a year.

Every year, some 20,000 unfortunate Australians find themselves having to resort to bankruptcy to resolve their unmanageable debt.

 

The hidden cost of debt

So what causes so many people to get into more debt than they can manage?

One huge factor which many people gloss over or under-calculate is interest charges. Interest is charged on all debt, except perhaps for a special introductory period, and is usually calculated as a percentage of the outstanding balance.

You’ll most often see interest charged per annum or p.a., which means ‘every year’. That means it’s an annual charge for as long as you have an outstanding balance. Let’s look at what this means in reality.

Say you take out a loan for $100,000 with an interest rate of 7% p.a.. The total amount of interest you pay will be $7,000, right? 7% of $100,000? Wrong! Unless you pay it back within a single year, the loan provider will keep applying that 7% charge to the balance every year until you’ve paid it all back. When you look at the total amount you actually pay back, the interest rate is a lot higher – we call that the ‘effective’ rate.

Staying with the same example, if you take five years to pay back that $100,000, the total interest will be $18,807. That’s an effective rate of 18.8%. If you take 10 years to pay it back you’re looking at $39,330 in interest charges, meaning an effective rate of 39.3%. And if you spread it over 25 years, the term of an average mortgage, you’ll be paying back $112,033 – more than the original loan amount – just in interest charges. That’s an effective rate of 112%! Doesn’t seem such a good deal now, does it?

You can see why lenders are fighting for your business – especially when it comes to home loans which are secured against your property and come with these massive markups.

Unsurprisingly, they don’t shout about the effective rate or rush to show you how much you’ll be paying over the course of a loan. Since 2012 lenders have been required by law to provide you with a fact sheet that shows how much you’ll pay back in total – but you have to ask them for it first. Similar legislation was introduced for credit cards which means your statement shows you the time it will take you to clear your balance if you only make the minimum repayments required.

It’s worth requesting a fact sheet from your lender because the headline interest rate advertised with a product is quite abstract – it’s hard to calculate what it really means and how it affects the total cost of a purchase. Debt can easily snowball if it’s not managed well, but knowing these numbers will help you make an informed decision about whether taking out a loan is the right choice for you.

 

How do interest charges work with credit cards?

So we’ve looked at how interest is applied to loans, but what about credit cards? We all know how lovely credit card providers are, so surely they wouldn’t dream of making us pay back double the amount borrowed? Well, let’s take a look.

Linda has been invited on a last-minute cruise with the girls – the holiday of her dreams. The thing is, it’s going to cost $2000 and she doesn’t have any cash. Not wanting to miss out, she puts it on her credit card instead, which charges interest at 15%. She has an amazing time.

Next month, Linda’s credit card bill arrives. She has three choices now: pay the balance in full; pay some of it off and carry the rest over until next month; or just pay the minimum amount the card issuer is asking for.

Option 1 – pay in full

With many credit cards offering up to 55 days interest-free from the date of purchase, they CAN be used without any interest accumulating. You’ll probably still have to pay an annual fee, and retailers may apply a surcharge of around 1% to your purchase, but paying your bill in full and on time means you avoid interest charges.

Unfortunately for Linda, this won’t be an option. She spent all her spare cash on holiday and has been too busy to think about other ways to raise funds.

Option 2 – at least pay a decent amount

Around four in 10 Australian credit card holders don’t go with option 1, and so the interest charges start piling on. The exact amount of interest will depend on how much you pay and how much is left outstanding, so it’s worth paying off as much as you can afford each month to minimise the damage.

If Linda can scrape together $250 each month to repay her debt, it’ll take her nine months to clear it (assuming she doesn’t buy anything else in the meantime) and she’ll have paid about $121 in interest – a rate of around 6%.

Option 3 – go with the minimum repayment option

Almost worse than throwing your money down the drain is only repaying the minimum amount stipulated by your card provider (at least if you throw it down the drain someone else might find it).

Linda’s card provider might ask for a minimum payment of 2% – that’s an easily manageable $40 for the first month. “Excellent,” thinks Linda, “I can pay for my holiday and I’ll hardly feel the pinch at all.”

The thing is, if she goes for this option, she’ll still be paying for the holiday an astonishing 14 years later and she will have paid a total of $4191 – that’s $2191 in interest, again more than doubling the initial amount paid. Card providers, busted! But how is this possible?

The problem, again, is the hidden cost of interest. With a rate of 15%, the initial $2000 card debt will rack up interest costs of $25 in just the first month. If Linda pays $40, only $15 of that is actually going towards reducing her balance – the rest just cancels out the interest charge. The same happens the next month, and the next month, and the next month, and the amount repaid is so small it takes 14 years to clear the balance. Surely no holiday is worth that?

In the table below you can see a summary of the three different options in this scenario.

 

Table 3.1: Impact of interest charges on $2000 credit card purchase*

 

Linda’s $2000 holiday purchase Pay off balance in full when statement arrives Pay $250 each month Stick to card issuer’s minimum payments
Value of purchase $2000 $2000 $2000
Interest charge $0 $121 $2191
Total amount paid $2000 $2121 $4191
Time taken to repay 55 days 9 months 14 years

*Assumes card rate of 15%

 

Now perhaps the true risk of snowballing debt is becoming clear. You would never choose to pay $4191 for a holiday worth $2000, but so many people do this without even realising because they don’t understand how credit card interest works.

So next time you’re about to swipe your card or pop those details in online, remember Linda and take a moment to think about what you’ll actually be paying for your purchase, especially if you’re not in the habit of paying your bill in full every month.

We have more tips for managing credit card debt here.

 

Let’s recap:

  • Personal debt is often necessary but needs to be managed wisely to avoid financial problems and bankruptcy
  • The way interest is applied means you can pay a lot more than the advertised ‘per annum’ rate
  • Ask your loan provider for a fact sheet so you can see the total cost of a loan over its lifetime (and evaluate whether it’s worth it)
  • Aim to pay your credit card balance in full each month. If this isn’t possible, make it a priority to pay it as soon as possible.

 

cost of your home loan

Minimising the cost of your home loan with extra repayments

06 May, 2016

For the vast majority of Australians, a home is the most expensive thing you’ll ever buy. You accept that you have to get a mortgage and the cost of your home loan will be a lot more than the property is actually worth, but at the end of it you’ll own the place outright and, with a bit of luck, it will be worth a lot more by then.

You spend plenty of time looking for a property that offers good value and negotiate hard to get the price down by a few thousand dollars so you can be confident you’ve got a good deal.

Why then, after all this effort, do you just sit back for the next 25 years and let the interest rack up on your mortgage as you just pay the minimum loan payments set by the bank? Taking a more proactive approach to your mortgage payments can save you tens of thousands of dollars on the cost of your home loan over the full term.

 

How much interest does a mortgage accrue?

Let’s take the example of Sam, who purchases an apartment costing $500,000. He puts down a 5% deposit worth $25,000 and covers the rest with a $475,000 home loan repayable over 25 years at rate of 7%. This means Sam has to repay $3,357 a month.

Over the full 25 years, Sam will end up paying $1,007,160 in repayments – that’s a whopping $532,160 in interest. He’s now paid more than double the initial cost of the property.

Sam would hope that the property will appreciate in value over those years, hopefully to become worth more than $1 million, but of course there is no guarantee of that. It has, at the very least, given him a place to live which he can later sell or pass on to his children. But if you look at the total amount of interest paid it works out at about $21,300 each year. That’s a lot of money by anyone’s standards.

 

Reducing the cost of your home loan

So what could Sam do differently to rake back a bit of that cash? As with any loan, the best way to reduce the cost of your mortgage is to make extra repayments. You may not have a lot to spare, but even a small amount paid regularly can make a big difference to the amount you end up paying in interest.

If Sam could manage to pay an extra $50 a week towards his home loan, it would reduce the amount of interest charged by a huge $90,000 over the course of the loan. And as well as saving that money, he’ll finish paying it back three and a half years earlier than if he just made the standard repayments, meaning more years to enjoy life debt-free.

Even an extra contribution of $20 a week would still knock over $40,000 off the interest costs.

Remember, the banks want you to only pay back the minimum each month because the extra interest adds to their profits. They aren’t going to phone you up once a month to see if you want to pay back a bit extra. If you’re going to make your mortgage work for you, you need to be proactive about managing your interest.

You can read about other ways to optimise your home loan here.

 

To summarise:

  • The effort you spend searching for the right home at the right price should continue when it comes to managing your mortgage
  • Interest charges on mortgages can total more than the value of the property itself
  • Minimise interest charges by paying back extra when you can; even a small monthly amount can make a huge difference over time