Ruan Vorster, Financial Adviser, PSG Wealth Somerset West
As July marks National Savings Month, we are reminded to boost our savings, but what should be done if there is debt to face – should you use any savings you might have to settle debt first? The answer to this question is not merely as simple as taking cash from an investment and settling all debt, as this would only be treating the symptom and not addressing the original cause of the situation.
But where does one start then?
In all financial decisions one should start with your personal budget. Before you can make the decision to use your investment capital to settle debt, you need to ensure that you do not fall into the same trap again.
Divide your expenses into necessities and luxuries and list your debt in order from highest interest rate to lowest interest rate. If possible, consolidate your debt into a product with the lowest interest rate. It is, however, a requirement that the debt still be repaid over the same initial period or faster otherwise you will lose the benefit of the lower interest rate, and may even pay more interest on the debt. Another possibility to consider might be to consolidate the debt in your home loan, for example, which would be at a much lower interest rate than a credit card or personal loan.
Once you have “structured” your debt in the most advantageous way possible, it’s time to decide on the plan to follow to settle the debt. The options are:
Repay the debt with a capital lump sum from you available investments, or
Repay the debt on a monthly basis
In order to decide which option to choose, you need to determine what the expected return on your investment would be in comparison to the interest you will be charged while you repay the debt. Here is an example:
If the future expected return on an investment portfolio is 10% and the interest you are paying on the debt is 14%, it would be beneficial to liquidate your investment and repay the debt. If the capital is not enough to repay all the outstanding debt, the remainder of the debt must be settled by way of a monthly repayment.
The next step is to revisit your budget where you listed your luxuries and necessities. Luxuries such as access to extra TV channels, takeaways from coffees to fast foods, and that gym contract that you don’t actually use can and should be cut. This money should be redirected to the repayment of your debt. As an additional measure, some retirement annuity products allow the owner to temporarily stop monthly contributions. These contributions can then also be rerouted to repay the debt even faster. Once you have repaid, you can simply start-up your retirement contributions again.
The repayment of the debt is, however, not the final step in the process. The decision to liquidate an investment and repay the debt has an opportunity cost attached to it. The opportunity cost is the lost compound interest on the capital liquidated and monthly contributions not made.
You now need to put a plan in place to try and make up for lost time. The first step would be to cancel all the credit facilities that you just repaid. This is to remove the temptation of using the credit card just this one time. Restart your contributions to your retirement annuity and voluntary investments by rerouting your debt repayments to the investments. Your financial adviser will be able to assist you in calculating how much additional contributions you will need to make to try and make up for lost time.
The reality is that most people who have debt to address, will have to do with less than what they want for long periods in their lives. It is, however, your choice to make these sacrifices earlier rather than later. These decisions will shape and determine your financial destiny. If you are unsure what is best for you, you should also consult your financial adviser.