ONE of the biggest issues in the recent Federal election was the size of the nation's deficit, which is predicted to reach around $30 billion. With the Government now focused on getting the budget out of the red and into the black, it's a timely reminder to take stock of our own personal debt levels.
Before coming up with a plan to reduce debt, people need to understand there are three different types of debt — bad debt, necessary debt and good debt — and they should be paid off in that order.
Bad debt refers to large credit card debt that is a struggle to pay off; necessary debt is debt that most of us need to have such as a home loan; while good debt is tax deductible debt, which includes loans for income earning investments, such as real estate or shares.
The general rule of thumb is to pay off bad debt like credit cards first as they have the highest interest rates. Once bad debts are under control, a person can then target other debts such as their car loan and home loan and save even more in interest.
Step-by-step guide to paying off debt and saving on interest:
1. Target credit card debt first:
Credit card debt is fine if you pay it off each month before interest is incurred. But if you have a large amount of debt sitting on your card, it could be costing you an astronomical amount in interest each year. Interest rates on credit cards are sometimes as high as 20 per cent, so it is important to get rid of this kind of debt as fast as possible. To do that you will need to make more than the minimum payments each month.
2. Consolidate credit card debt if you have multiple cards:
If you have several maxed-out cards, consider rolling all the debt on to one low-interest card to save on interest. Once you have done that, remember you still need to make more than the minimum payments each month to make any inroads. Once you have finally paid the card off, consider switching to a debit card.
3. Target car loans and personal loans next:
After your credit cards are under control, the next type of debt you should target is your car loan or any personal loans. As with credit cards, you can cut your interest costs on these types of loans by making additional payments. Car loans can have an interest rate as high as 12 per cent, while personal loans usually have an interest rate of about 14 per cent. Making extra payments is not advised for fixed rate loans, as penalties may apply.
4. Make extra repayments on your home loan:
Mortgages are often referred to as necessary debt. As the interest rates on home loans are much lower than other loans, this type of debt should only be targeted more aggressively after your credit card and other high interest loans are under control. The most effective way to save interest on your home loan is to make extra repayments each month. For example, the monthly repayments on a $300,000 mortgage over a 25-year term at 5 per cent are around $1,753. By increasing your monthly repayments by $400 you could save $76,316 in interest and pay the loan off seven years and seven months earlier.
5. Have an offset account on your home loan:
If you want to pay off your mortgage sooner and cut your interest costs, a home loan with an offset facility can be a quick and simple option. A mortgage offset account is simply a savings account linked to your loan account. The balance in the savings account is offset against what you owe on your mortgage, reducing the amount of interest you pay.
Dianne Charman is an Authorised Representative of AMP Financial Planning Pty Ltd, ABN 89 051 208 327, AFS Licence No. 232706. Any advice given is general only and has not taken into account your objectives, financial situation or needs. Because of this, before acting on any advice, you should consult a financial planner to consider how appropriate the advice is to your objectives, financial situation and needs.
To find your nearest AMP financial planner visit www.amp.com.au/findaplanner.