Five Steps to Financial Freedom Step 2 – Get Rid of Unnecessary Debt Part 2
This is a continuation of the Five Steps to Financial Freedom Series, for the previous post please refer to
Five Steps to Financial Freedom Step 2 – Get Rid of Unnecessary Debt Part 1
Five Steps to Financial Freedom Step 1 – Boost Your Active Income
It’s been quite a while since I updated this series, so let’s have a refresher on the various debts and corresponding interest rates. This is just a rough guide and may vary from country to country as well as personal credit history.
Types of Debt Instruments and Corresponding Interest Rates
Loan shark Debt/ Unlicensed Moneylender / Black market Moneylender – 100%-1000% per annum
Licensed Moneylender Debt – 20%-200% per annum
Credit Card Debt – 20-30% per annum
Personal Loan / Credit Line / Instalment Schemes – 3%-15% per annum
Car Loan – 4-10% per annum (based on housing loan interest calculation, rule of thumb is to double the car loan interest rate)
Mortgage Loan on a Non Performing Property – 1-6% per annum
Comparing Loan Interest Rates to Expected Investment Return Rates
Now let’s consider a reasonable investment rate which most financial planners think will be achievable. For more aggressive portfolio, average returns of above 15% may be expected, however, the chances of losses are higher. For slightly more aggressive portfolios, returns of between 7%-10% are considered reasonable. For the highly conservative portfolios, 4%-6% may be expected. Depending on the instruments, taxes may or may not be involved, the portfolio may produce a lower return net of taxes.
Now, compare the return rates to the loan rates, notice that almost all the loan rates are much higher than the expected returns? Only mortgage loan is low enough to be used to support leverage for higher returns. Pretty much all the other loan interests are a major drag on the personal finance. Only by investing, will you understand that paying such exorbitant interest rates will set you much further back in your journey to financial freedom because investment returns are much lower.
Understanding Personal Leverage Ratios and Personal Debt Servicing Ratios
Almost everybody will be in debt at some point of time as loans go a long way to helping us own assets which we may take many years to be able to pay fully in cash for like the house. The key is to understand your leverage ratio and debt servicing ratios, two primary measures of debt.
Leverage Ratio = Total Debt / Total Assets
The leverage ratio is a critical measure of how heavy your debt burden is. It typically means how much of your assets are actually financed by debt. The truth is, your net worth only consists of the equity portion of your assets, while the debt portion actually belongs to the banks or creditors. This can be understood from the equation:
Total Assets = Total Debt + Liabilities
So while debt is a useful instrument to boosting your investment assets, it is essential that you do not overborrow. A good rule of thumb is not exceed to 50% for the leverage ratio. So if there were to be a correction and your asset values fall by 10-30%, you would still be in a net equity position.
Debt Servicing Ratio = Total Debt Related Payments / Total Income
Debt servicing ratio refers to the percentage of income which is used to make debt related payments. A good rule of thumb is that debt servicing ratio should not exceed 35%. This is important as if too much of your income is used to repay loans, there may be little left for basic expenses and savings.
In the next part, I will be discussing tips on how to get rid of unnecessary debt.
For further reading, you may be interested in
Five Steps to Financial Freedom Step 2 – Get Rid of Unnecessary Debt Part 1
Five Steps to Financial Freedom Step 1 – Boost Your Active Income
My Journey to Financial Freedom
Personal Financial Statements Part 1 – Personal Accounting 101
Personal Financial Statements Part 2 – Income Statement