This is Part 4 of the series- How to Create Wealth – Do-It-Yourself Way. A recap- we learned how to Start Creating Wealth by calculating our Net Worth and identifying Assets & Liabilities in Part 1. Then we progressed to making Budgets, do Budgeting and knowing Savings potential in Part 2. We further went ahead to learn how to Make Investments using Financial Planning and Understanding various requirements of making Sound Invest Decisions in Part 3.
Now, we move to the villain of the story- Debt. Debt is considered a dirty word but still world has to live with it. If Debt Management is lacking in one’s life, he may spoil what he has and his future. Budgeting, Savings, Investments and Financial Planning all depends on how a person manages his debt situation.
Here we go. Remember the definition of net worth (wealth)?
Assets – Liabilities = Net Worth
Liabilities are your debts. Debt reduces net worth. Plus, the interest you pay on the debt, including credit card debt, is money that cannot be saved or invested—it’s just gone. Debt is a tool to be used wisely for such things as buying a house. If not used wisely, debt can easily get out of hand. For example, putting day-to-day expenses—like groceries or utility bills—on a credit card and not paying off the balance monthly can lead to debt overload.
Lots of people are mired in debt. In some cases, they could not control the causes of their debt.
People get into serious debt because they:
- Experienced financial stresses caused by unemployment, medical bills or divorce.
- Could not control spending, did not plan for the future and did not save money.
- Lacked knowledge of financial and credit matters.
Tips for Controlling Debt
- Develop a budget and stick to it.
- Save money so you’re prepared for unforeseen circumstances. You should have at least three to six months of living expenses stashed in your rainy day savings account or the Emergency Fund.
- When faced with a choice of financing a purchase, it may be a better financial decision to choose a less expensive model of the same product and save or invest the difference.
- Pay off credit card balances monthly.
- If you must borrow, learn everything about the loan, including interest rate, fees, and penalties for late payments or early repayment.
When you take out a loan, you repay the principal, which is the amount borrowed, plus interest, the amount charged for lending you the money.
Remember the discussion about earning compound interest in Part 3? The interest on your monthly balance is a good example of compound interest that you pay. The interest is added to your bill, and the next month interest is charged on that amount and on the outstanding balance.
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The bottom line on interest is that those who know about interest earn it; those who don’t, pay it.
People who go by planning, rarely use credit cards. When they do, they pay off their balances every month. When a credit card balance is not paid off monthly, it means paying interest—often 35 percent or more a year—on everything purchased. So think of credit card debt as a high-interest loan.
Do you need to reduce your credit card debt?
Here are some suggestions:
- Pay cash.
- Set a monthly limit on charging, and keep a written record so you don’t exceed that amount. (Remember your daily expense sheet from Part 2? Use it to keep track.)
- Limit the number of credit cards you have. Cut up all or surrender except one of our cards. Stash that one out of sight, and use it only in an emergency.
- Choose the card with the lowest interest rate. But beware of low introductory interest rates offered by mail. These rates often skyrocket after the first few months.
- Don’t apply for credit cards to get a free gift or a discount on a purchase.
- Steer clear of blank cheques offers like loans without security, zero processing fees or loans without documents that financial services companies send you. These are cash advances and loans that may carry a higher interest rate than typical charges.
- Pay bills on time to avoid late charges or increased interest rates.
Predatory lenders often target seniors and low-income people they contact by phone, mail or in person. After her husband died, 73-year-old Mrs. Sharda got plenty of solicitations from finance companies. She was struggling to make ends meet on her fixed income. To pay off her bills, she took out a 500,000 home equity loan that carried a high-interest rate and excessive fees. Soon she found she was even deeper in debt, so she refinanced the loan once, then again, and again, paying fees each time.
Mrs. Sharda’s children discovered her situation and paid off the loan. The lessons here are:
- Don’t borrow from Ram to pay Shyam.
- Never respond to a solicitation that makes borrowing sound easy and cheap.
- Always read the fine print on any loan application.
- Seek assistance from family members, local credit counseling services or others to make sure a loan is right for you.
Those who have used credit will have a credit report (CIBIL Report) that shows everything about their payment history, including late payments.
The information in your credit report is used to create your credit score. A credit score is a number generated by a statistical model that objectively predicts the likelihood that you will repay on time. Banks, insurance companies, potential landlords and other lenders use credit scores.
Credit scores range from under 300 to 900 and above and are determined by payment history, the amount of outstanding debt, the length of your credit history, recent inquiries on your credit report and
the types of credit in use. Factors not considered in a credit score include age, race or ethnicity, income, job, marital status, education, the length of time at your current address, and whether you own or rent your home.
A credit report that includes late payments, delinquencies or defaults will result in a low credit score and could mean not getting a loan or having to pay a much higher interest rate. The higher your score, the less risk you represent to the lender. A score above 700 is considered healthy.
Review your credit report at least once a year to make sure all information is accurate. If you find an error, the RBI guidelines require credit reporting companies and those reporting information to them to correct the mistake.
If you believe you are too deep in debt:
- Discuss your options with your creditors BEFORE you miss a pay
- Seek expert help, such as Financial Planner or Debt Counseling
- Avoid “credit repair” companies that charge a fee. Many of these are scams.
Debt is very crucial to manage, as investors get very easily temp to fall into it. The reason is DEBT IS A BUSINESS for few. Your bank, loan companies, credit card companies or home loan provider etc all make money off what you pay as interest. But it helps financing or funding dreams and causes. So one has to be vigilant of quality and quantity- Both.
With this, we end here. In Final Part of the series, we will learn about Wealth Protection. Till then keep sharing your views with us.