Dealing with Debt
One of the most common issues when it comes to financial struggles in the community is that of debt. In this article we aim to highlight some of the key aspects of this difficult topic; how people get into debt, how to avoid a vicious cycle of borrowing and how to repay all outstanding debt.
DEBT – A SYMPTOM, NOT A PROBLEM
A significant caveat before dealing with the subject is the importance of recognising that in almost every single situation, debt is not the problem, it is merely the symptom. The underlying cause of debt build-up is financial mismanagement. Indeed, dealing with the superficial issue of the debt rarely leads to long-term financial stability. In fact, sometimes, once a debt is cleared, a person becomes complacent and new debt builds up.
In order to ensure a debt-free life it will be necessary to inculcate into one’s life the general principles of financial stability, some of which are identified and analysed in these articles, whilst others can be found in Mesila’s aforementioned book.
REPAYING OLD DEBTS – THE WRONG WAY
One of the biggest complications surrounding debt is that often people in debt are so heavily weighed down by debt repayments, that they end up using disposable income toward repayment of old debts. This in turn, necessitates borrowing more money in order to cover new living expenses. The obvious result of this pattern is a never-ending cycle of debt.
Mesila recommends breaking out of this vicious cycle is by separating debt from living expenses, using what we call the “divide-and-conquer approach.” Debts and living expenses must be viewed as two distinct financial obligations and managed as two separate accounts. Disposable income must first be allocated to living expenses and only after this can debts be paid, or from a separate fund.
A family that runs an ongoing monthly deficit is headed for financial disaster, and if one finds that income is not covering living expenses, it may be necessary to implement emergency measures — which may include working overtime, implementing an emergency budget for a defined period, or even taking tzedakah — to close the gap.
LOANS ARE NOT A FORM OF INCOME
The other side of the divide-and-conquer approach is to ensure one appreciates that loans are not a form of income. The fact that credit is so readily available and often without necessarily incurring interest fees, is irrelevant. Any money used which must be repaid, is not disposable income.
Furthermore, it is important to point out the fundamental flaw in using any form of credit, whether credit cards, loans, post-dated cheques or any other. To elaborate, people often use credit cards to pay for items or services that they are currently unable to afford. This is short-sighted as money which is not available now will not necessarily be available later when the loan needs to be repaid!
To put it somewhat tersely; if the funds are available, then simply use a debit card; if the money is not available, then it is difficult to see what could justify spending money that isn’t there!
In some cases, a borrower may know with 100% certainty that the funds will be available in the near future – perhaps they are expecting a gift, a repaid debt or a bonus.
However, in the all-too-frequent case of wanting to make a purchase despite not having sufficient funds available at the time, there is a huge risk to one’s future financial stability – and this must be considered carefully before credit is sought.
IS USING CREDIT EVER JUSTIFIED?
The question is, can there ever be circumstances in which utilising credit is an appropriate option? There are a few benefits to using credit cards, which we will explain here, with a strong disclaimer that one must ensure they are capable of maintaining discipline at all times!
If one has to make a planned and/or critical purchase that is too large in one lump sum, but after careful budgeting, knows with certainty that making the payment in instalments would be manageable, then this can be good grounds for using a credit card.
An example of this is with car insurance, where paying in one lump sum can be costly but paying the insurance company in monthly instalments can incur extra charges. However, when using a 0% interest credit card, something that is prevalent, to pay for the premium, one can benefit from spreading the cost with monthly repayments to the credit card company but without incurring extra charges.
The trick is to have the discipline to use the credit card just once to pay for the item in question, and then to simply dispose of the card! If one feels they will not have the requisite discipline to do so, then having the credit card will be a much more costly option.
It can be beneficial to use credit cards or loans in other situations. If one has a poor credit rating and needs to improve their credit rating, for example, in order to get approval for a mortgage, then taking a credit card for small purchases which one can afford and has budgeted, then making regular repayments can have the effect of bolstering one’s credit score.
Another benefit to using credit cards is the rewards, such as frequent flyer miles, cashback, store points and more. Again though, the benefit of these rewards must never come at the expense of high interest fees or build-up of debt, otherwise the whole process is counterintuitive.
It is vital to ensure that whenever credit is taken, that repayments are made consistently because if not, one will pay extra charges and this will have an adverse effect on one’s credit score.
GETTING OUT OF DEBT
Finally, for those with issues of debt, here are a few points to help you get on the right track.
1. Stop using your credit cards!
Often, people in debt exacerbate the problem by continuing to use credit cards, either because of the problems we discussed at the beginning of the article, or because of a feeling that the debt is so high, another few hundred pounds won’t make a difference! The key in these situations to do everything in one’s power to stop using any form of credit.
2. Avoid interest
If you are paying interest on credit card debt, make sure you have attempted to reduce this by taking a balance transfer onto a 0% balance transfer credit card (not to be confused with a 0% purchase credit card). If you have a high level of outstanding debt, you may not be eligible for a new credit card but it is worth a try. Always make sure to apply with pre-approved credit card applications, rather than a full application, which, if unsuccessful, will have a detrimental effect on your credit score.
3. Get a loan
If the previous option is unavailable, then taking out a loan to clear the debt may be preferable than continuing to pay credit card repayments. The reason for this is that, typically, interest rates on loans are much lower than those on credit cards. Average credit card interest rates are approximately 17%, whereas as average loan interest rates are around 8%.
4. Seek professional advice
There are professional organisations that can help you to make what is known as a debt management plan (DMP). One such organisation is called Step Change (not a Jewish charity). However, as mentioned at the very beginning of this article, the debt is not the problem it is merely the symptom. We would strongly encourage anyone in such situations to apply for Mesila’s comprehensive family coaching service, which enables couples to tackle the issues at the root in order to ensure that a long-lasting financial management plan is created and implemented.