Are you digging a hole or are you getting out of the debt hole?
South African DEBT to savings ratio is in DECLINE – we are saving less than we did 10 years ago. It seems that not many care about providing for old age. Over the coming months, South Africans may feel happy about access to retirement funds, but most will not replenish those withdrawals over the coming 10 years.
Where to start: Reduce your debt now so that you can save for one day when you cannot save. Is there such a thing as good debt?
The “snowball effect” of debt is a term used to describe how debt can grow larger over time due to compounding negative interest and accumulating charges. How and why?
- Interest Accumulation: When you have debt, especially credit card debt or other high-interest, shorter term loans (anything more than 8 – 11% these days and for 6 months to 6 years), the interest on the debt is often calculated on the remaining balance. We have noted some debt comes at higher than – 21% per year! If you only make minimum payments/ or interest payments, the amount of interest you owe can quickly increase or the debt is cycled. This is because the interest is added to the principal balance, which means you’re paying interest on both the original amount you borrowed and the interest that has already been added. This is called the DEBT Cycle.
- Compounding Effect: Compounding interest means that interest is calculated on the initial principal debt value, which also includes any accumulated interest from previous periods. Over time, this causes the amount of interest you owe to grow faster and faster. For example, if you owe R1,000 on a furniture account at an annual interest rate of 20%, after one year, you’ll owe R1,200 if no payments are made. The next year, interest is calculated on the new amount R1,200, leading to even more debt and accumulation/ snowball effect.
- Minimum Payments: Many debt repayment plans require only minimum payments. These payments often cover only the interest charges and a small portion of the principal balance, which means the debt remains high. As a result, the balance doesn’t decrease significantly, and the interest charges continue to grow, exacerbating the debt. This keeps our citizens in a debt spiral. The SNOWBALL keeps rolling and growing.
- Fees and Penalties: Some debts come with additional fees and penalties for late payments or exceeding credit limits. These extra charges can add to the total amount you owe and accelerate the debt’s growth. Always try to negotiate a reduced capital settlement when you are ready to pay off your first / smallest debt.
- Behavioural Factors: The psychological impact of debt can also play a role. As the debt grows, it can become harder to manage and may lead to further borrowing to cover living expenses or make payments, perpetuating the cycle. You will stress out and your health may suffer – making money or the lack thereof your master.
Managing the Snowball Effect
To mitigate the snowball effect of debt, you should act today:
- Try to Make More Than the Minimum Payment: Paying more than the minimum can reduce the principal balance faster and reduce the amount of interest you’ll pay overtime. Even if it an additional R50 per month.
- Pay Off High-Interest Debt First: Focus on paying off high-interest debt first (often called the “avalanche method”), which can reduce the overall interest you pay.
- An alternative is to also try to pay the smallest debt first – small victories, grow in confidence and tackle the next.
- Consider Debt Consolidation: Consolidating multiple debts into a single loan with a lower interest rate can simplify payments and reduce interest costs. This is debt consolidation and may in some cases be an option but seek wise council.
- Create a Budget: Most South Africans feel they have a budget in their heads, also those who do have one never stick to it. Developing and sticking to a budget can help manage expenses and allocate more funds towards debt repayment. Try it for 3 months and see how your debt comes under control. Take your statements and group spending into headings and compare it over a couple of months. Set targets on 2 – 3 items that you want to manage better.
- Seek Professional Help: Financial advisors or credit counselling services can offer personalized strategies to manage and reduce debt.
Understanding how debt compounds and using strategies to combat the snowball effect can help manage and eventually eliminate debt. This will be the point from which you can use the SNOWBALL effect of compound interest (7th or 8th wonder of the world) by starting to save what you would have spent on interest payments and debt.
Article Reference: https://businesstech.co.za/news/finance/765057/south-africans-are-digging-themselves-into-a-hole/
