Debt Reduction blog: 11th September 2008

how to clear debtsThere are two types of debt, good and bad. It really is that simple, broadly speaking there is personal debt and investment debt. Personal debt would be anything that is spent on assets likely to depreciate rapidly (some would argue housing belongs in there recently!) or that has no ongoing inherent wealth creation once used. If you were to say that with the two debt types they can be either good or bad then personal debt would lean to the ‘bad debt’ side, although it doesn’t mean it’s an actual bad debt in the sense that payments are being missed.

An example of this would be money spent on a car, clothes, furniture etc. with personal debt you should always try to ensure you have a good reason for incurring it in the first place, not simply out of ‘ease of use’. If your car broke down a new (new can also be second hand!) car may be warranted, a new car for the craic may be affordable but from a debt perspective its deplorable.

Then we get onto what can go under the heading of ‘investment debt’ and this would lean towards being ‘good debt’ because it is spent on something that is likely to create at least some level of wealth in the future or it invests in an asset not likely to depreciate.

yield curve determines bank lending marginsHere is a question: Mike borrows €20,000 t0 attend an advanced training course in whatever job he does, is this personal debt or investment debt? Is it good or bad?

Answer: It is personal debt because the loan would be made directly to Mike and not secured on some kind of asset, having said that it bucks the trend of being bad because it is an investment in his future which will likely increase his future earnings potential. For this reason (in my opinion) it would be best to call this investment debt despite the paperwork which says otherwise, it is an investment in himself so that he can earn more by having advanced qualifications in what he does for a living.

When it comes to a hierarchy of debt it is important to realise that not all debts are created equal. Broadly speaking this is a list of the debts that you should service firstly (most important for your credit rating/personal circumstances & to avoid court orders etc.)

1. Mortgages
2. Car loans
3. Education loans
4. Tax (I’m not supporting evasion! but you can defer taxes if required)
5. Medical/Utility bills
6. Credit cards & unsecured loans
7. Subscriptions/dues etc.

the order of debt repaymentsThis is not an exhaustive list but it covers common things that many of us are familiar with. If you find that you are having issues with servicing debts then you will need to remember this hierarchy when deciding which ones you can pay. The majority of lenders are willing to set different terms if you can service at least part of the debt you owe, this may mean increasing the term or in some cases they may even write off part of the loan if you can clear most of it.

the most important thing in debt reduction though is to get rid of expensive money first and that usually means clearing the list from the bottom up, unsecured loans and credit cards attract the highest interest rates. If you are a regular saver it is also a good idea to put part of that savings towards debts because most debts cost more than you make on savings (deposit rates), if you have enough of a buffer in your savings it may be worthwhile to actually stop saving and instead just aim for pure debt reduction because debt has an ongoing costing, money in a current account may earn almost nothing, but a 300k mortgage at 5% will cost at least €15,000 per annum just to service the interest portion – that’s before you pay off even a penny!

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