The South African economy is facing significant challenges brought about by domestic policy failures, negative international sentiment and an extreme drought. And the consensus view appears to be that things are going to get worse before they get better: there’s a possible credit downgrade on the horizon and the South African Reserve Bank, in an attempt to rein in inflation, is expected to continue to raise rates (totalling as much as as 1.5 percentage points!) throughout 2016.
In trying times such as these many people are looking at ways to pay down debt and shield themselves from economic shocks. This could be a positive as many South Africans have become far too reliant on debt (often with encouragement of financial institutions) to fuel their lifestyles. But not all debt is created equal!
Good Debt & Bad Debt.
Broadly speaking debt can be divided into two categories: good and bad. Good debt is used to grow wealth by acquiring appreciable or revenue generating assets. Good debt is an investment. Bad debt on the other hand is used to fund lifestyles and offers little to no long term reward.
If you’re going into debt to buy a property in an area likely to return good purchase price or rental growth you are taking on good debt. If you are going into debt each month to buy the latest fashion items you are taking on bad debt.
So called ‘bad’ debt is necessary from time to time: a refrigerator, some form of transport, food and clothes are examples of necessities in the modern world that can be paid for using credit. That said, it is important for people to take into consideration the costs of acquiring that product versus the potential benefits.
It’s A Trap! Maybe.
Phone contracts, vehicle finance, store cards and even funeral plans are so prevalent (I receive at least two SMSes a day) it is hard to imagine that these offerings could pose a danger to personal wealth. But any kind of finance deal used to acquire a product or service is a potential wealth trap and should be researched thoroughly before taking up the offer.
You need to determine what the value of the product is and then determine what you will be paying for that product over the term of the agreement. Is the long term cost of acquiring that new item now really worth it? The monthly payments for that new appliance seem so low but remember: you’re making at least 12 of those payments. And you’re not only paying for the product itself: you’re likely being charged service fees and interest. Sometimes these additional costs can be exorbitant.
A case in point is the recent story about the gardener who bought a R6000 washing machine on 36 month payment plan. After 36 months that R6000 washing machine would have cost him R18 000! Research is important: these companies are not giving you these products and services out of the goodness of their hearts.
Status symbols: Money in the bank is better than a Mercedes in your garage
Car finance in particular poses a significant risk to future wealth. When buying a car on credit it is important to keep in mind the fact that your vehicle is depreciating in value. You will not sell your car for a profit. If you have to buy a vehicle on credit, take the time to do the math and ask yourself these important questions: what is the car worth now? How much will I be paying if I use credit for this purchase? Is the difference really worth it? Do I really need the newest model?
Cars are problematic because they can be very emotional purchases: utility often takes a back seat to the symbolic display of wealth, success and status. While there are obviously differences to take into consideration when choosing a make and model; many people mistake ‘luxury’ for ‘quality’.
Here’s an example using some rounded figures:
Mr X and Ms Y both have R15 000 a month that they could, if they chose to, spend on a luxury vehicle. They both consider the same Mercedes Benz: if you could buy it outright, a new Mercedes Benz E200 Elegance would cost you around R700 000.
Mr X goes the finance route and gets a rate of 10% over 5 years for that new Mercedes. His monthly instalments would be around R15 000 per month for 60 months.
After 5 years Mr X will have paid R200 000 in interest for that Mercedes, paying R900 000 in total. After 5 years Mr X’s luxury car will have depreciated roughly 34% (luxury models depreciate slower generally) and his vehicle will be worth only R462 000. Mr X’s ‘investment’ will have made a net loss of R438 000.
Ms Y decided not to use the whole R15 000 she has to spend each month and bought a car half the value of the Mercedes (still a R350 000 car!!!). She received a similar rate and loan term but her monthly repayments are half of Mr X’s at R7500. She then decides to put the R7 500 she now isn’t using on car payments into a 6.5% interest bearing account.
Over the 5 years Ms Y pays R100 000 in interest bringing her payment for the car to R450 000 in total. After 5 years her somewhat less luxurious car will have depreciated closer to 60% so her vehicle would now be worth only R140 000. Her ‘investment’ in a vehicle will have made a net loss of R240 000.
BUT the R7500 per month she tucked away in that savings account now totals R450 000 AND has earned interest of R80 000.
After 5 years Mr X only owns a used Mercedes but Ms Y has a used car AND R530 000 in a savings account.
If, after the 5 years, both Mr X and Ms Y traded in their vehicles Mr X would have go the finance route again, albeit for smaller amount, whereas Ms Y could pay for her new vehicle in cash, perhaps buying a model one tier higher than her new car (even taking inflation into account). While Mr X had to continue paying a portion of his previous R15 000 monthly payment as a new instalment, Ms Y is entirely debt free.
A similar scenario plays out for almost every product available on credit: Do you really need that iPhone 6 when the iPhone 5 is so much cheaper? Do you really need that refrigerator that makes crushed ice in the door (you know what I’m talking about!)? Could you get that washing machine second hand?
Now, let’s talk property…
As a continuation of our scenario let’s say that after those first 5 years Mr X and Ms Y buy those new cars but also look at buying a property worth R1 500 000.
It is important to note that a bank will take into account your ENTIRE credit history and current credit status. They take into account things like loans, credit card debt and vehicle finance. The bank will even look at your exposure to potential debt: things like overdraft facilities and high limits (even if the go unused!) on your credit card. If you have many debts, even debts you’re currently servicing, it is unrealistic to expect the bank to give you further finance as your risk of defaulting on one or all of those debts is high.
Back to our scenario:
Mr X and Ms Y want to now buy a second property and apply for home finance. To qualify for a home loan of R1 500 000 at 10.25% (current prime) over 20 years they would need R14 724.66 to cover the monthly repayments. Can they, given their financial positions after purchasing new cars, afford this?
Mr X trades in his old Mercedes for the newest model. With inflation the newest model now cost R900 000. That means that after he trades in his R462 000 old model he still requires finance for R438 000. At 10% over 5 years his monthly repayments are R9330 Rand.
He finds that he only has R5670 left over to spend on financing that property he is interested in. This is only a little over a third of the amount he needs! Because of that flashy car and the loan he used to finance it he cannot now afford to buy a property.
MS Y trades in her car and uses her cash savings to purchase a new vehicle. She can afford a vehicle worth R670 000 and does not have to finance it. The R15 000 that she has available will easily cover the loan repayments and she purchases the property. She wisely rents the property out for R5000 which she uses to pay her loan off sooner.
Mr X again finds that he has new Mercedes, a depreciating asset, and significant debt. While Ms Y also has significant debt she too has a new vehicle, a property (an appreciable asset) and a new and relatively reliable source of income from renting it out. If Ms Y continues the extra payments into her home loan account she will have paid off that debt in 10 years.
In addition to falling into a bad debt trap which has significantly hampered the growth of his wealth, Mr X also put himself at risk: in the event that he was suddenly unemployed his indulgence in the wrong kind of debt would have left him little breathing room. Ms Y has shown wisdom, long term planning and, even though she holds more debt at the end of our second scenario, has mitigated the risk of sudden financial shocks by acquiring an appreciating and revenue generating asset.
If you’re undermining your wealth just to purchase things to show off how wealthy you are, you might have problem.