The Beast of the Night called Debt

EMERGENCY POST!

While cycling to work this week I saw a newspaper headline telling me that South Africa is "the world's most indebted nation". I was going to post something about where to bank or where to invest in South Africa this weekend, but debt is such a serious emergency that this post cannot wait any longer!

The Beast of the Night Called Debt
Photo credit Pablo Piedra (CC-BY 2.0)

To see why debt is such a terrible thing. Let's take a look another look at the formula that tells us how how our investments grow with compound interest:

which we can compare to the formula that tells us how our debt grows:

See any difference? You shouldn't, because they're the same. That's right, the same power of compound interest that can help you buy freedom when you invest, acts against you when you're in debt.

When you have an investment it grows exponentially and when you have a debt it also grows exponentially - according to the same laws of mathematics. It is said that "Those who understand compound interest, earn it. Those who don't, pay it." My true hope is that you will come to truly understand compound interest. If you can't wait for what I plan to write in a future post - begin your studies here and work your way up.

The current prime lending rate in South Africa is 9,25%. Credit card rates are anywhere between 14% and 23%. Borrowing money at any of these rates can only lead to real financial difficulties. If we take inflation into account, then the prime lending rate is effectively about 4,25% and credit cards are between 9% and 18%. If you have any debt at these rates, then paying off this debt gives you a guaranteed real return (above inflation) equal to that rate. So paying off debt fast and aggressively is the wisest thing you could do.

Good debt? Rare and risky if it exists.

People often talk about "good debt". I'm not going to completely refute this idea, but I do feel the need to highlight the only conditions under which debt can be "good":

1. The interest rate that gets paid on the debt is low. This automatically excludes all credit cards as well as borrowing money for a car. Oh, and buying anything on hire purchase is a seriously bad idea.
2. The borrowed money is being put to good use. This means that you're not borrowing money for general life expenses or leisure expenses. Putting the borrowed money to use means you're using it to earn more money (a concept referred to as leveraging). This can definitely be profitable, but you really need to know what you're doing. The borrowed money could be to start a business or to inject additional capital into an existing business.

Personally, I don't like debt at all. I believe that you should up for anything you want to buy with cash. Yes, even a house. But I do acknowledge that money might need to be borrowed in order to produce an income with which to do the saving (as in the business example above).

So credit cards... what role do they play in our quest for financial freedom? Firstly,

Credit cards are not for borrowing money. 

They are for managing your cash flow better. Most credit cards in South Africa give you about 55 days interest free (the actual number of days is not important, only that it is more than one month). This means that when you use your credit card to buy your groceries and pay for strictly necessary expenses the actual cash you have earmarked for these expenses sits in your bank account earning interest! As long as you pay your credit card in full, every month, then you will never pay interest. This is the only way to use a credit card! Never pay only the minimum amount due (it's a trap!). Never let a month go buy without paying the full amount owing. If you don't have the self discipline to do this then you should not have a credit card.

We aren't fortunate enough in South Africa to have the types of credit card rewards programmes that they have in the US. So we might not be able to actually earn money from credit cards, but we can shop around and choose a card that will cost us the least.

The best card that I could find is from Virgin Money - there are no monthly, yearly or admin fees. Internet banking with this card is free. They do have some other rewards, but none of them are really relevant to our family's needs.

I'll do another post on the rewards programmes that we do have in South Africa, but in the meantime I'll share my conclusion: they're not worth it. Now this conclusion depends on your individual spending patterns and circumstances so you will have to do your own calculations, but in most cases the rewards escalate with spending. If you're planning on living a frugal lifestyle to generate fuel for your financial independence engine then rewards programmes won't benefit you because the very thing they reward is consumption.

For more takes on just how serious debt is, let me point you towards Mr Money Mustache who tells us that "debt is an emergency" and jlcollinsnh who says that "debt is an unacceptable burden".

So to summarise:

1. Don't get into debt in the first place.
2. If you already have debt, pay it off as fast as possible.
3. Use credit cards wisely and not for their advertised purpose.

Now go forth and defeat the Beast of the Night called Debt!