Creative Finance Newsletter NOVEMBER 2008

Get Ahead On Your Debts

Debt consolidation is often portrayed as a way out of trouble.

But for many it’s actually a smart way to get debt-free more quickly by reducing the interest being paid.

Many of us have several loans and debts. For example we may have a home loan, a line of credit, car financing, a personal loan, a few credit cards, and some store finance for furniture or renovations. These commitments will all be charged at different interest rates, perhaps with account fees and other charges.

Whilst it may have been logical to set-up and keep these commitments separate, it can mean that you are paying more interest than you have to.

And with the recent dramatic events in global financial markets, many lenders are putting up their rates and fees across many financial products – notwithstanding the recent RBA cash rate cuts.

Credit Cards

For example, cards currently have very high interest rates up to 19.99% and higher, with annual fees ranging from $0 to $450, and interest-free days from nil to 62.

Whilst some of the more expensive cards will have rewards and loyalty programs, these may not make up for the differences in interest charges, fees and interest-free days.

Personal loans, car loans and store finance also show wide variations, with some very high interest rates. For example, interest-free finance through a store is an attractive option provided that the debt is cleared within the term. If not, these loans often revert to extremely high interest rates – 20% and higher are not uncommon.

Balance Transfers

The smart way to reduce this debt more quickly is to minimise the interest rate and fees being charged, whilst maintaining the same monthly payment as before.

A good example is to watch out for low interest or even interest-free balance transfers that are regularly offered by credit card providers. You can apply for a new card and then transfer the balances from other credit cards, which will then be charged interest at a very low rate or even interest free, at least for a period of six months and occasionally for the lifetime of the balance transferred.

This can be a good short term solution, but often the interest rate then reverts back to a (comparatively) high rate. So then the whole process of application and balance transfer has to start again.

Also, this doesn’t help to reduce the interest rates on some store finance, personal loans and car financing.

Smart Consolidation

A more comprehensive solution is to consolidate all of the debts into a relatively low-interest product such as a home loan. The recent reductions in interest rates on many home loans have made this option look even more attractive.

“Reduce interest and debts more quickly.”Consolidation can be done by either using an existing spare capacity, for example using available redraw or an unused line of credit, or by refinancing the entire home loan to borrow a larger amount.

This can often result in more than halving your average interest rates. For example you could refinance a credit card at 18.75% to the standard variable mortgage rate of around 8%. On a debt of $10,000 this represents a reduction in interest of around $1,000 per annum.

Similarly, by refinancing a car loan of $25,000 at, say, 12.75% to a home loan of around 8% you could see interest savings of nearly $1,200 per annum.

Of course in both of these examples the amount of saving would reduce over time as some of the debt principal is paid off, but it would still be substantial.

Now here is an important point. By keeping the new consolidated payment the same as the sum of the various payments being made previously, then the debt will reduce more quickly as less interest is being paid, so more of the payment is reducing the debt itself.

Words of Caution

This strategy does work, but you should watch out for the following:

  • Cancel The Old Debts or Cards. If you transfer the debts (e.g. from credit cards) then you are at risk of building up new debt in its place, which isn’t the idea. By cancelling the old credit cards and loans this won’t happen.

  • Early Repayment Costs. Some loans may incur a penalty if paid out early, which can negate some of the benefit of refinancing the debt.

  • Establishment Costs. Organising a top up on your home loan, or refinancing altogether, will incur some costs. Again you should check what these costs are and factor them into your calculations.

  • Secured Debt. Refinancing personal loans and credit cards using a home loan means that you are converting "unsecured” debt into “secured” debt. In other words, if you became unable to pay the home loan then you would put your home at risk.

Conclusion

If used correctly and by keeping the new payment at the same level as the sum of the old payments, then using your home loan to consolidate your debts is a good way of reducing interest and clearing personal loans and credit card debts more quickly.

Is Your Income Protected?

Over 25% of Australians will be disabled for more than three months of their working life.

But how many of them will have sufficient cash reserves to replace their incomes and pay for medical expenses?

It’s quite a sobering thought to realise that, according to the Australian Bureau of Statistics, one in four Australians will be disabled enough to be away from work for over three months. Now, whilst sick pay and holiday pay will cover some of this period, many people will be left without any income at all.

This is significant as most people rely on their income to fund their lifestyle and commitments.

For many people, this means that they would have no money to pay for normal living expenses such as the mortgage, school fees, running the car, food, clothing, bills, etc. Also, they may be faced with significant medical expenses.

One way of funding this is to have some cash saved in an emergency account, perhaps in a mortgage offset account or as potential redraw in your home loan account.

As an alternative to funding these living and medical expenses from savings or borrowings, people could consider the option of income protection insurance. According to the Investment and Financial Services Association, though, less than one third of working Australians have any income protection insurance at all. And yet without an income, many people would not have enough cash savings to fund their lifestyle for more than a few weeks.

What is income protection insurance?

As its name suggests, this type of policy is designed to provide an income in the event that someone is unable to earn an income through sickness or disability.

“How will you pay your normal living expenses without an income?”This type of insurance can replace up to 75% of your normal gross income whilst you’re unable to work. This still means there would be a gap, but 25% of your income is easier to find or achieve via cutting back on expenses.

It’s worth noting that benefit payments are considered income and therefore subject to tax.

In most cases, the insurance premium is tax-deductible. This means that the after-tax cost of the insurance can be significantly less than the “published cost” of the premium.

The waiting period before the benefit is paid can vary between policies and insurers. Typically it ranges from 30 to 90 days, with the premium costing less for a longer waiting period.

The claim benefit period or length of time that the benefit is paid can also vary. Typical periods are two years, five years, or even until retirement age. As you would expect, the premium is higher for the longer claim benefit period.

Another key element of this policy is your occupation. White collar workers are generally charged less than manual workers due to the lower risk of injury.

Other factors influencing the premium charged include:

  • Age
  • Gender
  • Health and pre-existing conditions
  • Whether the person is a smoker.

Normal Employment

Income Protection Insurance policies are often complex, particularly in the definition of employment. Some policies will pay out if you are unable to perform the duties of your normal occupation. Others, however, will only pay out if you can’t perform any occupation including lower paid or unskilled work.

Other Items

There are other items to consider as well:

  • Index-linked. Does your policy increase the benefit being paid in line with inflation? This will be important if you are unable to work for a long time.

  • Guaranteed to renew. If this isn’t built into the policy, then the insurance company may reassess your circumstances (e.g. health) on each annual renewal and could then either raise the premiums or refuse to cover you altogether.

Which Insurer?

One option to consider is whether you can take out this insurance through your superannuation fund. Because they buy in bulk then they may have been able to negotiate a lower average premium from their preferred insurer.

However the net premium, terms and benefits of this option should be compared to others in the marketplace to ensure you’re getting a good deal.

Also, as with all insurances and financial products, income protection should be considered as part of an overall financial plan.
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