Why is getting rid of unnecessary debt important? Simple, useless debt is a drag on our personal finances, increasing our expenses with high interest expenses. Not only is the debt painful to the pocket, it is stressful to the mind and body as well. Speak to anybody under mounting credit card debts; you will know they are really stressed by trying to make payments.
Every useless debt we pick up takes us further and further away from our goals, instead of getting Passive Income, we are getting Passive Expense instead! Debt management is a really large topic in itself and I will not attempt to address every single aspect in this Five Steps Financial Freedom series, I will however try to cover the main points.
Let’s look at some of the main culprits.
Loan shark Debt/ Unlicensed Moneylender / Black market Moneylender
This is the worst scenario one can be in. Loan sharks/ unlicensed money lenders whatever you call it do not play by the rules. They often make the borrowing really easy but make paying it off extremely difficult. Interest rates of such debt are known to hit over 100 percent interest per month! Once you get in, it is very tough to get out. Worse still, they will make your life hell by harassing you and your family constantly. Never ever step into this category.
Licensed Moneylender Debt
This debt is only slightly better than the previous. However, the interest rates are also extremely high, as high as 200% a year. The good news is that they are regulated by the government; the bad news is that many of them still employ harassment tactics used by the loan sharks. For more information, read Staying Away From High Interest Rate Money Lenders. Again, stay away from these sources no matter what.
Credit Card Debt
Most young people are guilty of carrying credit card debt balances and rolling them over month after month just by paying the minimum charges. Many also do transfer balance from an existing card to a new card at lower interest rates, which is supposed to be good, but they end up charging their previously paid credit card to the max again. With a credit card limit of up to 2-3x the salary of an individual, it’s easy to see how people can end up owing lots of money with couple of maxed out credit cards.
Banks are also extremely cunning in that they allow you to pay a minimum of say $50 per month, but they will charge you up to 24% interest on your remaining balance! How often does one make investments which can yield over 20% per year?
Personal Loan / Credit Line
Banks are just as guilty of pushing personal loans as are licensed moneylenders. While the interest rates are not as high as credit cards, they can still be between 5% to 15% per year depending on your credit status and the loan amount. When the loan check comes in the mail from your bank, resist the temptation and just tear it up, remember it’s a loan, not cash.
Car Loan
Car loans are one of the most misunderstood loans as they are structured differently from a housing loan. People often claim that car loans which have 1-3% interest rates are very cheap, cheaper than housing mortgage interests in some countries, or is it? Car loan interests are calculated based on the principle for the whole tenure while housing loan interests are calculated based on the principal outstanding. A simple rule of thumb is that the car loan interest rate is nearly double in housing loan term rates! So a 3% car loan interest is actually closer to 6% if you want to compare to housing loan.
Now you know why you should pay up your car loan as soon as you can. For those who live in the city like Singapore, public transport is a viable alternative. If you have to own a car due to work or so on, buying a second hand car can be a huge money saver as well.
Mortgage Loan on a Non Performing Property
While housing mortgage loans are typically one of the cheapest loans you can get, it really doesn’t make sense to be paying financing costs for a property which is not generating any income or capital appreciation. Examples are where the location is not as hot as it used to be or the demographics have changed into one of lower income and increasing crime rates. It may also make sense to cut loss on a property if the fundamentals have downgraded dramatically. Since housing loans are usually very large in amount, clearing them off also helps to improve your leverage ratio dramatically.
As we can see, there are many types of unnecessary debt which can be a huge burden to us. We have to identify if we have any of these debts and understand the impact of what this debt has on us. As we work through the different classes of debt, we also find out that most of these debts have interest rates far exceeding that of many asset yields like dividends and rental. As long as we have these debts, Financial Freedom will be difficult to achieve. If you do not have any of the above debts, Congratulations! You are one Step closer to Financial Freedom!
This post has gone on to be much longer than I expected. As such, I will have to continue this Step 2 is the next post. In the upcoming post, I will discuss concepts like leverage ratio and tips to reduce the debt burden so you can be a step closer to Financial Freedom.
