After you’ve paid all your bills, you don’t have any money left over. To get the things you need, you use your credit and store cards. Next month, the next round of bills leave you in exactly the same position. If that sounds familiar, you should know you are not alone.
In this article we’ll help you understand your debt and offer a step-by-step plan to get you into a better financial position. There is hope!
The most common way a creditor makes money is by charging a fee for lending you money. This is called interest, and it’s a very important part of the reason why it’s so hard to get out of debt. Creditors also make money by charging an account or administration fee. Lastly, in-store credit forces you to spend your money at a certain store, making your creditor even more money.
Why is it important to know how creditors make money?
When you borrow money by using a credit or store card or by taking out a loan, you don’t just pay back the amount you borrowed. In addition to the money you borrowed, you have to pay back interest. As long as you have an account, you also pay an account fee.
Let’s say you really want to buy a belt. You don’t have enough money to buy the belt this month, but your bank said you can pay back the money you borrow on your credit card over 12 months. If you divide the price of the belt into 12 months, you can easily afford it. The problem is, when you pay back the bank, you have to pay back the price of the belt divided by twelve, plus a monthly account fee, plus interest. The true cost of the belt you bought on credit is the total cost of the belt, plus one year’s worth of account fees, plus interest.
This is true whenever you borrow money. If you have multiple accounts, the account fees and interest can quickly become more than you can afford.
The hardest part of this process is facing the monster. It’s time to open the latest round of bills to help you get out of debt. Grab a piece of paper or open a spreadsheet, and let’s begin!
- Make a list of all the accounts you have.
- Check each statement and write down the interest rate and account fee for each account.
If you’re struggling to find your interest rate and account fee on the statement, call the accounts department. You don’t have to give them your account number to get this information, so you don’t have to worry about them asking for money.
- Next, write down the minimum amount you can pay back for each of those accounts (that’s normally indicated at the bottom of the statement) and add them all up. Seeing that amount might shock you, but don’t worry. You’re already closer to getting out of debt.
- Make a list in which you order your accounts by interest rates, from highest to lowest. Make a second list where you order all your accounts by account fees, from highest to lowest.
Now that you have all the information, choose which account at the top of each list you could avoid using for just one month.
If you’re afraid that you won’t get through a month without using the account at the top of the list, go down the list until you find an account that you don’t rely on so much. Once you have more self-confidence, you can come back to the expensive one.
The good news is you don’t have to pay back more than the minimum amount. Your only challenge for the month is not to use that account. If it’s a physical card, make sure to leave it at home when you go out.
If you managed to make it to the end of the month without using that account, enjoy the feeling of being in control of your money. You have just proven to yourself that you can do it if you try. When your statement comes this month, pay the minimum amount and see if you can go through another month without using it.
It’s important to do this with the same account. It might not feel like you’re doing much, but in just a few months you’ll see the amount you owe reduce significantly. Before long, you’ll have paid off that account, which will empower you to achieve even more with the next one.
If you didn’t make it, don’t be too hard on yourself. Like all good habits, this one can take a while to cultivate. Make sure that you’ve given yourself the best chance at success. Take another look at your list and make sure that you selected an account that you don’t rely on too much. Consider choosing an account that you use less often, and try again. You will get there eventually.
If you repeat step two and three often enough, you’ll soon pay off everything you owe on that account. It’s very important that you now close that account completely if it’s an in-store account, or to reduce your limit significantly if you don’t want to get rid of your credit card completely.
The idea of closing a line of credit can be very frightening, like you’re letting go of a life line. Just remember, for as long as it took you to pay off the account, you managed to get on without it. If you do need something from that store, you’ve now got the amount you paid off every month to buy what you need in cash.
It’s not enough to merely pay off accounts. Most accounts charge a fee merely for having the option of credit. You pay that whether you owe money or not. Unless you want to pay the monthly account fee even when you’re not using the account, you need to close your account completely.
Paying off debt is almost as addictive as getting into debt. Now that you’ve closed one account, it’s time to move on to the next one. This time, pay the minimum amount, but add some or all of the money you paid towards the account you closed the previous month. You’ll end up closing this account far faster than the previous one, and the one after that even faster!
Repeat this process until all of your debt is settled.
Long-term debt is sometimes unavoidable. Few of us have enough cash to buy a house, so we need to take out a home loan. A home loan is a better type of debt, because the debt buys an asset.
TIP: Not sure what an asset is? Read the explanation here.
If you can no longer afford to pay the home loan, you can sell the house and pay back the bank. The bank can also sell your house if you don’t pay back your debt. Because they are much more likely to get their money back, banks tend to charge less interest on home loans.
While it’s cheaper to borrow money to buy a house than it is to borrow money on your credit card, you still have to pay a lot of interest to the bank. Home loans are generally paid off over a very long period. The longer it takes to pay back the loan, the more interest you pay and the more expensive your house becomes.
When you add the interest you have to pay to the original price of the house, you’ll notice that you are paying a lot more for the same house than you intended to. Your aim is to pay as close as possible to the original amount for the house.
The easiest way to pay as little as possible for your house, is to pay back more than the minimum amount the bank expects. Whenever you have a few extra rands at the end of the month, add that to your home loan repayment. Each additional amount will reduce your repayment period and make your house a little cheaper.
Avoid borrowing more money from your home loan as you pay it off. Build up your emergency fund to help pay for unplanned expenses.
TIP: Find out how to build up your emergency fund here.
Borrowing money to buy a car can become very expensive. Just like short-term debts, different car financing companies charge different interest rates to lend you money. If you haven’t yet taken out financing, start by shopping around for the lowest possible interest rates.
Be very careful of selecting car financing with a balloon payment. The balloon payment option brings down the minimum amount you have to pay every month. Many people fall for this, because it allows you to buy a much fancier car than you can afford. Unfortunately, you don’t actually own the car until you pay the outstanding amount at the end of your financing period. To own your car, you have to make a huge cash payment that few can afford. Your only other option is to sell the car you’ve been paying off for a few years, taking out financing for a new car and repeat the cycle. This means the bank or financing company always owns your car.
Car debt sometimes works differently from other debt. On your home loan, for example, the interest you have to pay is calculated daily on the money you owe. If you pay your home loan back faster, you pay less interest because you owe the bank less. With car financing, the interest on the loan is sometimes added as a fixed amount at the beginning of your loan term and not calculated on the outstanding amount. This means you pay the full interest amount, whether you pay the loan back faster or not. If at all possible, try to negotiate a loan where you only have to pay interest on what you owe. That way you can repay your loan faster and pay less interest. If you can’t, the only savings you’ll realise by repaying your car loan faster is the monthly account management fee.
These days it seems that everyone is living in debt. What’s more, Covid-19 has increased unemployment and under-employment, and thrown many of us into financial crisis. What might have been a modest debt can quickly become unmanageable if you lose an income source or have unforeseen expenses.
In this short series we face up to debt. We look the monster in the eye, and offer you practical steps to deal with your creditors and get out of debt.
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