Financial Literacy & Independence for Teens - Step 3 - Debt Management
KEY POINTS
Debt can be a powerful financial tool when properly harnessed for the right reasons.
Excessive debt can become financially devastating while simultaneously negatively impacting relationships and your mental health.
Prudent budgeting, emergency savings, and prioritizing financial security over excessive discretionary spending are critical to a successful lifetime of debt management.
Debt – A Fresh Perspective
Debt management is a key step to gaining financial literacy.
Debt is often viewed with negative connotations. However, it is possible to view debt from a different perspective.
When wisely managed, debt can be a powerful tool for growth and opportunity.
The decision to take on new debt is derived from a unique set of facts and circumstances. We will use three broad categories to illustrate debt’s positive and negative aspects: good, necessary, and bad.
Good Debt
An investment in your future or in something with the potential to appreciate in value would be considered a good use of debt. Such may include:
Education Loans
The pursuit of higher education (e.g., university, college, skilled trades) will result in acquiring knowledge and skills that can lead to enhanced career opportunities and the best top paying jobs.
From a qualitative perspective, a career that is chosen and pursued will typically align with the individual’s personal interests and passion. The long-term benefits are beyond dollars and cents.
Mortgage Loans
A mortgage provides a structured way to build equity while simultaneously providing a place to live and raise a family. Home ownership has been a cornerstone of wealth generation and financial independence for many countries.
The monthly mortgage payment reduces a portion of the principal owed and contributes to an increasing net worth. The interest may be tax deductible in some jurisdictions.
The ability to make all mortgage payments on time and in full will help build a higher credit score (see below) and potentially reduce future borrowing costs.
Historically, housing prices have shown periods of high volatility; however, they have typically increased over the long term in many jurisdictions.
Business Loan
Entrepreneurship can be a great tool for obtaining financial independence. The continued rise in prevalence of the gig economy continues to fuel the entrepreneurial movement.
A loan can provide financial resources to support talent acquisition, research and development, equipment, inventory, customer acquisition, physical expansion, and more.
Necessary Debt
There are some forms of debt that are required and do not qualify under the rather restrictive definition of good debt referenced above.
Automobile Loan
Automobile values typically depreciate. However, that does not necessarily deem all related loans as bad debt. Access to a vehicle may be required for several reasons including employment, education, training, medical access, athletics, family relations, and more.
It is important to consider more than just the financial impact of the monthly loan payment. Your long-term financial plan must integrate the total cost of operating an automobile including, repairs, maintenance, and depreciation.
Medical Loans
Medical expenses can be unexpected and substantial. Not all medical expenses are covered by health insurance.
Medical related debt may be required to fund the cost of surgeries, treatments, and ongoing care. Medical providers may accommodate a degree of negotiations over the cost and repayment terms of such costs.
Bad Debt
Generally, debt related to things that do not increase in value or depreciate over time is considered bad debt. There are exceptions as noted above under Necessary Debt.
Unexpected circumstances (e.g., job loss, emergency) may arise that require accessing bad debt for a limited time. Such should be minimized to the extent possible.
Always avoid financing discretionary / non-essential expenses.
The following are examples of debt and should be avoided whenever possible.
Credit Card Debt
Credit card debt attracts extremely high interest rates. It may be tempting to only pay the minimum monthly payment required. However, such will result in the compounding of high interest rate balances and potentially lead to being trapped in a cycle of debt.
Consumer Loans
Many companies will offer loans related to electronics, clothing, vacations, and more. These loans come with high interest rates and result in the individual paying substantially more than the item is worth.
We recommend exercising the concept of delayed gratification. Delay the purchase of such discretionary items until payment can be made in full.
Payday Loans
Payday loans are conceptually designed to be repaid with the borrower’s next paycheck. They often carry higher interest rates and fees than credit cards making them a very expensive form of borrowing.
These loans are typically taken out during periods of financial distress. Individuals can quickly find themselves in a payday loan trap as the high interest rates and fees increase liquidity pressures beyond what the budget can accommodate.
Do You Have Excessive Debt?
The concept of excessive debt will vary depending on the individual and their unique circumstances. Some may refuse to access credit under any circumstances while others may continuously access credit if they can maintain the minimum monthly payments.
We provide the following rules of thumb to help you quantify your relationship with debt.
Debt-to-Income Ratio
This ratio compares monthly debt payments to monthly income. A ratio exceeding 35% is often a warning sign of excessive debt.
Debt Repayment Period
The debt repayment period equals the length of time it will take to repay the debt. The debt may be considered excessive if the repayment period restricts cash flows to such a degree that it impacts lifestyle, short-term goals, or long-term goals,
Credit Utilization Ratio
This ratio measures how much available credit is being utilized. A ratio exceeding 30% may indicate excessive debt.
Emergency Fund
The existence of an emergency fund is not a direct indicator of excessive debt. However, the lack of an emergency fund may indicate an inability to save due to excessive debt obligations.
Typically, individuals should aim to have emergency savings equal to 3-6 months of living expenses.
Impact of Excessive Debt
Debt is often assessed from a purely quantitative perspective. Unfortunately, there is more to debt than the ongoing servicing costs.
Cash Flows
Borrowers must ensure that they fully understand the timing and repayment amounts related to fees, principal, and interest. Additional fees may be incurred if payments are missed or if the individual decides to repay the debt prior to the term stipulated in the contract.
Restrictive cash flows may have a detrimental effect on lifestyle, short-term goals, and long-term goals.
Limited Savings
An allocation of income skewed towards debt servicing and debt repayment may lead to limited savings, if any. This may necessitate the deferment or resetting of milestone goals (e.g., education, trip, wedding, housing, retirement).
Debt Trap
Individuals are prone to falling into a debt trap due to excessive debt servicing requirements. Such occurs when the debt obligation exceeds an individual’s repayment capacity.
Legal Intervention
Excessive debt may eventually lead to long-term consequences that can take years to recover from. Such may include wage garnishment, bankruptcy, and foreclosure. These events can have a devastating effect on an individual’s credit score which will impact borrowing terms offered by future creditors.
Career Limitations
The need to maintain a stable income and not incur relocation costs may limit an individual’s ability to pursue other career opportunities.
Lifestyle
A restriction of financial freedom will require making difficult trade-offs. Discretionary expenses and experiences will eventually need to be sacrificed. Such may include clothing, concerts, dining out, movies, travel, and more.
The adverse consequences of social isolation may manifest themselves to the extent group experiences and interactions are reduced.
Strained Relationships
The financial stress resulting from excessive debt may lead to conflicts and disagreements with family, friends, and significant others.
Mental Health
All the above issues can lead to anxiety, depression, and other mental health issues. The impact can be compounded as individuals may be reluctant to discuss the issues with others that may be able to help.
Debt Reduction Strategies
As discussed, there are circumstances and opportunities that justify accessing the credit markets. It is important to avoid excessive debt. The following steps can help ensure your debt burden can be accommodated by your financial plan.
Avoid New Debt
The most obvious step is to avoid taking on new debt unless absolutely necessary.
The purchase of all discretionary items (e.g., dining out, subscriptions, streaming services, entertainment) should be carefully considered prior to purchase. This translates to eliminating impulse buys and delayed gratification. If a purchase must be made, try waiting for an attractive sale.
Non-discretionary items (e.g., rent, food, medical) should be subject to comparison shopping (in person, on-line, newspapers). Bulk shopping during sales should also be carefully considered.
As noted above, an emergency fund can be instrumental in avoiding debt related to unexpected emergencies.
Fun Fact
Borrowing $100 today for pair of jeans may have an opportunity cost exceeding $2,000.
How?
You could have invested the $100 for 40 years at 8% and increased your retirement by $2,172.
Create a Budget
It is difficult to determine how much debt you can handle without a budget. You need to learn how to make a budget that works for you. A budget should integrate your income, living expenses, emergency funds, short-term and long-term savings goals.
A budget will highlight potential areas where costs can be cut and reallocated towards debt repayment.
Automatic Payments
Establish automatic payments to ensure minimum debt servicing payments are never missed. This will reduce your debt, ensure you do not incur expensive penalties, and maintain your credit score.
Increase Cash Flows
Consider opportunities to increase your cash flow. Such may include negotiating a raise with your current employer, entering the gig economy in your spare time, or selling unused personal items.
Debt Prioritization
Multiple debts require a clear and concise repayment strategy. A key decision driver will be the interest rates associated with each credit facility.
Prioritize paying the highest interest rate debt first while maintaining minimum balance payments on the other credit facilities.
Debt Consolidation
Consider consolidating multiple debts into a single loan or credit card with a lower interest rate. Such will decrease the overall interest rate costs while simultaneously reducing the administrative burden.
Credit Counselling
Professional advisors can be vital to managing debt. A reputable professional credit counsellor can offer debt management programs and personalized advice to manage the debt in an effective and efficient manner.
BOTTOM LINE
Debt can be equally beneficial or detrimental to your short-term and long-term financial goals. Be sure to create a budget and update it regularly. Create an emergency fund to insulate yourself against unforeseen financial hardships. Prudent planning will ensure you have a healthy respect and relationship with debt for years to come.
