Debt, in some form or the other, is part of our financial affairs whether we like it or not. And it can be a useful way of building wealth if it is managed carefully and wisely. For example, you can borrow money from a bank to buy an asset – a resource of economic value that generates income from its productive use. Investment property is one example. Hence investing in income generating assets can be a good idea.
If you’re already in the property market, the home equity you’ve accumulated – part of your property’s value – can help you buy a second property. This time, you will not need a deposit as large as the initial investment. If the rental market is booming and your tenants pay you more than loan installments, municipal fees and property manager fees, the wealth-creation machine will kick into gear. But debt bothers many people.
Here are the four biggest misconceptions about loans. Recognizing them will help you develop a more nuanced approach to debt.
What are the fallacies?
⦿ All debts are bad:
In fact, debt is a problem when you cannot manage it and it starts managing you. One of the simplest ways to tell if debt is working for you or against you is “leveraging”. It refers to the use of a loan to acquire an asset worth more than the value of the loan. It is also known as positive or favorable leverage.
Those who take unsecured loans are unfavorably leveraged when the loan is driven by consumption. Often there is nothing to show what you have spent on. Unsecured loans have a higher interest rate to compensate for the lack of collateral.
⦿ Only financially careless people are in debt:
This is another misconception. Next to unsecured loans, the loan portfolio of most South African consumers consists of home loans. The most realistic way to gain entry to the housing market is through a mortgage or mortgage. If your mortgage loan is paid off within a reasonable amount of time then you are doing the right thing. This would mean that, in the long run, the value of the property would exceed the home loan amount that was earlier taken to purchase the property.
⦿ Two misconceptions about mortgages:
After paying the mortgage deposit, you will not have to pay any other charges. This is not correct. Banks charge a fee for opening and closing a home loan account. Premature repayment of home loan can also attract penalty. So be sure to read the fine print regarding discharge fees or closing costs.
If you keep paying your mortgage repayments on time, you will be able to repay the loan sooner. This is not true – even if interest rates fall and your mortgage repayments drop, your home loan stays on the loan term of 20 to 30 years. Many banks will quote a monthly mortgage repayment amount that looks cheap at face value but is actually based on a 20 year term.
It is important to have a goal of when you would like to end the loan repayments in order to pay off your mortgage. To achieve this goal, it is necessary to implement a plan. If you do not do this you may lose your mortgage.
⦿ Keep an eye on profit
As we close out the year and enter the festive season, it is a good time to remember your financial goals and how not to set yourself up for financial problems by unknowingly swiping or tapping your credit card. Don’t let it be born.
For better or for worse, debt is a part of our financial portfolio. But the road to financial empowerment isn’t always an easy one – financial planning can help you keep track of the gains.