Top ways to beat the debt trap

DEBT can be one of the most lethal forces to confront in the world of personal finance.

It has killed several members of corporate Australia in the past couple of years amid the global financial crisis, and with interest rates about to rise and unemployment heading higher, consumers are likely to be next in line for the pain.

But debt’s deadly power can also be harnessed for good, delivering huge gains to your wealth when used wisely and with long-term goals in mind.

First, the ugly side.

Federal Government Insolvency and Trustee Service figures show total insolvency activity in Australia rose 11 per cent to 36,479 cases last financial year. Most of these were bankruptcies (27,503) and 86 per cent of bankruptcies were non-business related.

So how do you avoid drowning in debt? Financial experts say it is important to have a plan, know what debts to clear first, and act to ensure you don’t become a sad statistic.
A step-by-step plan

MyBudget director Tammy May says people can find it quite difficult to decide what debts to repay first, particularly if they are flooded with repayment requests.

"The first type of debt to pay off is your really bad debt, such as credit cards and highinterest personal loans taken out for non-taxable purposes such as holidays, goods and furniture," she says.
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Non-taxable debt, also known as private debt, cannot be claimed as a tax deduction. May says the debts with the highest interest rates should be paid off first.

"If you have a personal loan with a high interest rate you are looking to pay off, make sure you will not incur any penalties for doing this," she says.

The chief executive of credit union Community CPS Australia, Kevin Benger, says the highest-interest debts are usually the hardest to control.

"Credit cards, store cards and mobile phone accounts are the big ones that most people generally don’t control well, so get rid of them if you can," Benger says.

Hit the home loan

Most people’s biggest debt is their home loan and once all the other personal debts are under control it is a good idea to focus on reducing the mortgage as it can save you thousands of dollars.

"You can make a big dent in interest costs if you shorten the length of your home loan,’’ Benger says. "Look at ways to shorten it, either by fortnightly repayments or making payments off the principal from time to time if you have got spare cash."

The managing director of Club Financial Services, Andrew Clouston, says the mortgage should be targeted only when all higher-interest debt is cleared. People having problems should not be afraid to seek help, he says.

"A lot of banks now have help lines for people struggling, and a lot of brokers offer advice, too,’’ he says. Too good to be true? May says when signing up for an interest-free deal for goods, people should always read the fine print and understand what they are doing.

"Interest-free and no repayment financing sounds great, and it does work for some people, but there is a catch and many people have found themselves paying more money than what the goods are actually worth," she says.

"What is not pointed out is if an item is not paid for during the interest-free period then often the interest changes to an extremely high rate and interest can be charged on the original amount owed regardless of what is paid."

Clouston says once the interest free period expires on these deals, rates can be about 30 per cent a year. "It can make them virtually impossible to pay off," he says.

"Make sure you have the debt fully paid by the end of the interest-free term.

"It requires discipline, and discipline only comes if you are aware of the term of the debt you have taken on."

Consolidate

NAB financial planning manager Judy Power says an effective and popular debt reduction strategy can be to consolidate higher-interest debts such as credit cards and store cards within a loan where the interest rate is lower.

"Make sure you have a committed repayment plan, because people can easily get into trouble with credit card debts when they don’t have one," Power says.

A danger can be when people consolidate debts into a cheaper loan but then go back to their old spending habits and rack up the credit card again.

"If consolidating, cancel the credit cards or just keep one card with a small limit on it," Power says.

Benger says people with many different debts can find it difficult to keep track of them. "I always advise people to keep a maximum of two cards,’’ he says.

"Any more than that can be a recipe for disaster.

"And don’t be seduced by introductory offers. There’s always temptation. Nothing comes without a cost."

Debit cards

NAB has noticed an increase in customers opting for debit cards – where people only spend their own money.

"Less people are getting credit cards and debit cards are now more readily available," Power says.

"More and more people are using their own funds, rather than borrowed funds, which is a good thing."

Good debt Investment loans for property and shares are good debt, and usually come with a tax deduction for the interest expenses, but there are potential pitfalls.

Benger says people need to "avoid some of the risk of having too much debt".

HLB Mann Judd partner Steven Toth says once taxdeductible debt is repaid it can no longer be claimed, so investors need to consider their future needs.

"You can only claim a tax deduction for debt you incur for investment purposes," he says. "You can use offset accounts rather than pay the debt off."