Be credit healthy.
Ruby Connection is proud to partner with the Davidson Institute to bring you our 2020 International Women's Day webinar series.
Borrowing money is one way to enhance your lifestyle or increase your investment opportunities. Using credit wisely may help you to get ahead. However, if it’s not managed well it may have a negative impact on your financial future. Therefore, it’s important to understand why we borrow, the different types of loans available, how to manage the loan effectively, and what the pitfalls of not borrowing well may be.
This video may be helpful for anyone who:
- Is borrowing, or contemplating borrowing, for the first time.
- Wants to know more about using credit effectively.
- Wants to know more about keeping credit well managed.
This is a great starting point. Why not continue your financial education journey with the rest of our webinar series:
Welcome to our International Women’s Day financial confidence webinar on Being credit healthy. Using credit is an integral part of our financial journey however if not managed well it can have a detrimental effect on our financial position instead of enhancing it. This webinar looks at the basics of borrowing to help you get on the right footing and staying healthy when using credit.
Now before we get into ‘Be credit healthy’ let me just share a few stats with you that reinforce my thinking that it's absolutely essential for women to become more financially savvy and independent. Firstly, times are a-changing with millennial women now leading the way in home buying and investments – a far cry from the days (only 30 years ago) when women required a male guarantor to borrow money.
And, these days women are our household CFO’s, managing 80-90% of household finances despite being less financially confident than men. However, we still have a long way to go. Currently, the average annual salary for women is $44,000 which means that on average women need to work 59 days more than men to earn the same amount. And while the gap is closing, women are still retiring with 47% less super than men, and with a longer life expectancy, it needs to last them longer too.
So to my way of thinking it’s imperative, as we work toward ‘Each for Equal’ this International Womens’ Day, that we take a more proactive interest in our finances sooner rather than later. But given you’re all here today I think I am preaching to the converted.
So, over our next 20 minutes or so, we are going to lay the foundations for using credit efficiently to achieve our goals and staying credit healthy. The three key areas that we are going to focus on are: • Why borrow? Looking at the reasons people borrow money. • Different types of debt have different purposes and should be matched to the purpose of the borrowing. • If you are going to borrow, what are some of the things you should take into consideration when making that decision?
Firstly, I want to look at “Why borrow?” because a common reason for people getting into financial difficulty is because they have borrowed for the wrong reason or they have the wrong type of borrowing for their original purpose. There are three main reasons we borrow money.
The first and most common reason for borrowing is to buy things now rather than later. Whether it’s a house, a car, furniture, computers, or simply that new pair of shoes or the latest electronic gadget … we want these things and are not always prepared to save up to buy them because the time taken to save means we potentially miss an opportunity.
The second reason people borrow is to invest or, if you like, boost our wealth generation potential. We may wish to buy an investment property, share portfolio, increase our super contributions or, invest in a business. Effectively investing is a way to increase our wealth so we can buy more stuff in the future by selling the investment or using the income from the investment.
The final reason people borrow is to alleviate a mismatch in cash flow timings. For instance, perhaps your pay is due to be deposited in the bank account on Thursday, but a bill needs to be paid a few days beforehand. You know you will have the cash in a few days’ time, but you need it today. This is where credit cards and short-term debt may be useful.
Whatever the reason for borrowing the main thing you have to remember is you will have to repay it. Credit is a useful tool when used wisely however, I must say, it isn’t always used well. Now saving and borrowing in practical terms are two different ways of achieving the same goal – getting the thing s that you want. So we have the choice of cracking open the piggy bank, and using our savings if we have enough. But what if we don’t have enough and we need this thing right now?
That’s where we may need to borrow. The key to determining whether to use your savings or get a loan lies in understanding the requirement around when you need to access the thing that you are purchasing and how using a loan will change the total cost of the purchase.Ultimately, it’s about getting the right balance between saving and borrowing, then borrowing well to ensure the credit supports your overall goals.
So, let’s have a look at the example of buying a car. If you were to save up to purchase a car that cost $25,000 and you could save $470 per month, it would take you a little over 4 years to save up $25,000. But in 4 years’ time is your $25,000 going to purchase the same type of car that it will now? The good news is, it will only have cost you roughly $23,800 of your own money (the other $1,200 is the interest that accrues on your savings over that time).
On the other hand, if you were to borrow to purchase the car now on an unsecured loan it would take you 7 years to pay off the loan at the same rate as you are saving, that is $470 a month. Including interest and fees, this would actually use about $39,580 of your money. So that’s nearly $40,000 a big increase on the $25,000 you paid for the car.
Remember too, whether you save or borrow, during the time of ownership you will also have to pay for the running of the car … fuel, maintenance and so on, which is another thing that needs to be budgeted for. This may mean you are not able to repay at the same rate as you were saving and thus it would take you longer to repay the loan and it would cost even more.
The second reason we borrow is to invest. Typically, most of us think of using our own money when we invest. However there is a good reason to consider borrowing to invest. So, let me take you through an example to explain why people may want to borrow to invest.
Let us say you invest $100 of your own money - this can be referred to as your equity. Let’s keep the maths simple and say that you can get a return of 10% … which will make you a profit of $10. However, if you use your $100 equity as a 20% deposit and borrow $400 you would have $500 to invest.
If you could still get a 10% return this calculates out to earnings of $50. Of course, you will have to pay interest on the $400 borrowed. Again, for ease of calculating, let’s say the interest rate on the loan is 5%, therefore, costing $20 and leaving a profit of $30 – higher than the original $10 you were earning on your $100.
Borrowing to invest can provide a positive outcome where the returns are higher than the cost to borrow. But remember if the costs to borrow outweigh the income from the investment then this will put you in a worse position and even if the investment is not performing you still have to repay the loan. So if you’re thinking about borrowing to invest, it’s a good idea to get professional advice before heading down that path.
The third reason people borrow is to cover mis-timings in cash flow … that is, when you have an expense, generally unplanned for, that needs to be paid before you have the cash available to pay for it. Many people will ration their money from payday to payday to ensure they have enough for known expenses, but what if the car breaks down? Or you need to have some emergency plumbing done? If you don’t have enough cash available, then you may choose to borrow to cover the shortfall.
For example, my friend Mary gets paid on a fortnightly basis, so she has her rent set up to come out of her account the day after payday; she does her grocery shopping and any general errands the weekend after she gets paid; as well as allocating money for her phone, electricity bill and car rego. So, the balance of her account tends to fluctuate like the graph on the screen.
But then last week her car needed some emergency repairs … while she knew she would have the money once she got paid again, right now she needed to pay for the repairs and she didn’t have enough cash available, so she needed to borrow to cover the shortfall, but then repaid it as soon as she got paid.
This is where people can sometimes run into trouble. If these little mis-timings are not repaid but continue to accumulate, say on a credit card, it’s possible to end up with an unnecessary debt that can become costly and even detrimental to your financial profile. Debt created by cash flow mis-timing should be repaid as soon as possible, and if they’re becoming a regular occurrence then it might be time to look at how you're spending your money and whether your budget needs to be adjusted.
Now that we know why we borrow, let’s take a quick look at the different types of borrowing or the different types of credit available. Now before I talk about the different types of borrowing, a cardinal rule you should always remember is to ‘Match the life of the loan to the life of the asset’.
Let me give you an example. A friend of mine wanted a new car, they did not have enough cash to buy it, but they had a redraw facility on their home loan which they decided to draw down to pay for the car. My friend thought this was great, as it was a lower interest rate than they would have paid on a personal loan, and they did not have to increase their repayments.
The problem was though that the car died last year after a good 8 years of life, but they’re still paying it off as part of their home loan. Also, they no longer had room left in their home loan, or savings, to buy another car and have had to borrow more and are now effectively paying off two cars. You should always think about what you are buying and how long it will last. You need to ensure your repayments will pay it off before it's reached the end of its useful life.
The first type of credit we’ll look at is short term loans … such as pay day lenders, overdrafts, credit cards, and buy now pay later schemes. These types of loans should be used for timing differences. I need to pay something now, that I can afford to pay from my regular income, but I will not get paid for a few days or weeks. A pay day lender will advance you money against your next pay. The interest rate is often high and the penalties for not repaying are also high.
You may be able to get an overdraft through the bank. This may be arranged or unarranged. Unarranged means a payment comes out of your bank account which does not have enough cash in it, but the bank allows it to go through putting your balance into debit. You will be charged a fee and interest until you put the money back into the account.
An arranged Overdraft, on the other hand, is an overdraft you apply for and a limit is put in place. You will generally be charged a lower interest rate than an unarranged overdraft and it would be unlikely that an overdrawn penalty fee would be applied as long as you stay within your approved limit.
If you have a card with an interest-free period and will pay the balance off within that period, then you should only need to pay the card fee. If you do not think you will pay it off in the interest-free period, you would most likely be better off with a card that has a lower interest rate.
A recent addition to short term borrowing are things like AfterPay, and ZipPay, and the likes, which offer interest-free, buy now, pay later’ services. These services are often offered by the retailer, who gets paid directly by the lender, and then the borrower (you) repays the lender via a series of direct debits to your account, which is set up when you register with the lender.
While this might seem like a great deal, if you are going to use these services please make sure you understand the terms and conditions and ensure you have the money available in your account when repayments are due. You don’t want your purchase to end up costing you more in the long run due to late payment fees by the lender, and dishonour fees from your bank.
When buying larger items, that will take more than one pay period to pay back you may still use your credit card, but it may be more appropriate to use some type of personal finance, or vehicle finance if you are purchasing a car. Some different types of personal finance are:
Personal loans are mid-term finance (often 2 to 5 years) with regular repayments. You will usually pay interest and fees and once the loan is paid off the thing you purchased is yours. Another type of personal finance is ‘Rent to Buy’. With this type of finance, you are paying a rental for the item with the intent of buying the product at the end of an agreed term. This is often used for furniture or household appliance purchases.
Take care to add up the total rental and the amount to pay at the end to see how much it will actually cost you. A consumer lease is like rent to buy, but you may not have the option to buy it at the end.
With Interest-Free Periods or buy now pay later you should look closely at the terms and conditions. Quite often you get charged ongoing fees instead of interest and there can be severe penalty rates if you miss a payment. Similar to a Rent to Buy, you should check if the repayments add up to the total cost as you may have a large payment to make at the end.
Car loans are like personal loans and may be secured by the vehicle, or unsecured. Generally unsecured will mean you have a higher interest rate and maybe a shorter term, which will increase your repayments. Home loans are just longer-term personal loans secured by a mortgage over your home. They may be up to 30 years as you would expect your home to last for this period.
Remember if you pay off a little more than your repayments, you will generally pay it off more quickly and not pay as much interest. An investment loan is used to purchase income-producing assets or assets that will get capital growth. The interest rate will be higher than a home loan and the term of the loan may be shorter than a home loan but generally longer than a personal loan.
These are the main types of borrowing, now let’s look at some of the things to be aware of if you do make the decision to borrow. First of all, borrowing does not come free. There are various costs, including interest and fees, that will need to be paid and you will have to pay the money back.
The costs can generally be broken up into: • Set up or establishment fees – the financier will charge to set up the loan. The amount will vary depending on the complexity of the transaction. • Interest – the premium you pay to use someone else’s money. • Many financiers will apply a monthly account keeping fee or something similar so you may have ongoing Fees or Charges.
• You may also have Exit Fees. Because a financier borrows the money for your loan and may break that borrowing when you repay early there is often an early exit fee. • Penalty Fees – are applied if you do not pay on time or breach the conditions of the borrowing. The amount and type of fees charged will depend on the type of borrowing, the terms and conditions of the borrowing and the security provided for the borrowing.
When comparing different types of borrowing or different financiers’ offerings make sure you have taken into account all interest, fees and charges as some lenders may make it sound better by offering you a cheaper interest rate, but their fees and charges may be higher. Once you enter into a borrowing arrangement with a bank or financier it incredibly important to ensure you meet the repayment arrangements.
Make sure you know when your payments are due and that you have the money available. Let’s face it sometimes we do run short and may not be able to make a repayment. Instead of just hoping for the best … that the bank won’t notice … be proactive and let them know you are going to be late. By making other arrangements they know you are committed to making the payment but just can’t make it right now.
The more you communicate with the lender the less likely they are to take action that could be detrimental to your credit history. The key pitfall or cause of bad borrowing is when our repayments and interest can’t be met from our budget. Some people have a tendency to pay for this shortfall with their credit cards. Let me tell you this is a slippery slope that can lead to financial ruin.
If you find yourself getting into this situation go back to your budget and work out what expenses you do not need and cut back. Remember all borrowing should be repaid from your regular income or sale of assets. If you understand why you borrow and know it fits within your income, then you will generally be engaging in good borrowing.
Be wary of just paying the minimum repayments on your credit cards. If you had a $10,000 outstanding and you paid the minimum 2% with a 20% interest rate it will take you 77 years to pay it off and cost you $43 thousand in interest. By paying as much as you can you reduce the interest cost and display yourself to be a good and responsible borrower.
When it comes to borrowing, your credit history is very important as this forms a large part of the credit providers decision to lend you the money or not. It’s simply a record that is kept by credit reporting agencies, such as Equifax, Experian, and Illion, of all your past credit enquiries and applications, details of any existing borrowing, your repayment history, and if there are any court judgements or bankruptcies filed against you. These records are often summarised as a credit score.
These records are accessed by a credit provider whenever you apply for a loan or take out a mobile phone payment plan. It tells the credit provider about your past conduct and helps them decide whether you are a good risk and are likely to repay a loan.
You are also able to access the information kept about you and it’s advisable that you do so on a regular basis to make sure it remains accurate. You are actually entitled to a free credit report each year, and you can request it from one of the reporting agencies online. Some of the agencies even offer a subscription service to notify you when your record is accessed. This is particularly useful to identify fraudulent activity on your credit profile.
Given your credit score is so important, what can you do to ensure it stays healthy? Things like making repayments on time, paying your bills on time, not making unnecessary credit applications, and checking it regularly to make sure it remains accurate.
Borrowing money to buy things, invest or just to cover timing differences can enhance your life, but make sure you are getting the right type of loan for what you are borrowing for. Remember the cardinal rule ‘Match the life of the loan with the life of the asset’. Understand the full cost of any finance and ensure you have budgeted for the repayments.
Finally, make sure you pay all your commitments to keep a clean credit record. These are the keys to remaining credit healthy. In closing, let me thank you for joining us today for ‘Be credit healthy’.We trust you found this information useful and relevant and I encourage you to check out the other webinars and resources on the Davidson Institute website to help build your financial confidence. Thanks again and I wish you every success with keeping your credit healthy.