SIMON BROWN: Get to grips with your debt

When looking at a business to invest in, one of the important issues is debt. We expect to see companies carrying some debt — ideally for growth and not day-to-day expenses. If the debt can create returns ahead of the cost of the debt, then it is positive for profits and good for the business.

As is always the case, it is not the debt number itself; rather it’s the ratio that matters and this week I want to take some of these debt ratios and apply them to our personal finances.

First, we have to have a solid understanding of our personal debt; that is everything from home loans and car finance to unsecured debt such as credit and store cards. This means a personal balance sheet that adds up all assets (things you own) on one side and all liabilities (debt) on the other side. The difference is your net worth.

Using this we turn to debt:equity which is your debt reality to your net worth. This is very much a moving target. A young family starting out, having just bought a house, with a car loan as well, will have high debt but little “wealth” as they start out. Somebody in their fifties, on the other hand, should have a lot more wealth and less relative debt.

The trick is to track the trend. You could add some previous years’ data and start to see which way it’s going.

Digging more into the debt, what’s the monthly cost of your debt? Then what is that relative to your monthly income? There is no hard and fast rule on what the debt repayments should be, but ideally target 30% and maybe as high as 50% if you are paying off a home loan.

Again, check the trend of this cost of debt every month, remembering that the cost of debt changes with interest rates so this will, at times, be a volatile chart.

But if it has been trending higher simply because you’ve been taking on more debt, then it could well be cause for concern.

The next step in this assessment is your debt maturity profile. This is basically how long it will take until the debt is paid off. A home loan will be decades if the purchase is recent. A car loan would be a couple of years, maybe five, while credit and store cards will be much shorter in duration.

This maturity profile helps you understand how quickly you can reduce debt. The home loan is not going anywhere any time soon. But those shorter debts certainly can be managed down by paying them off and not re-spending the debt.

Also, check the rates being charged. Generally your home loan will be the cheapest, then your vehicle finance, followed by unsecured credit and store cards.

Being on top of your debt doesn’t make it go away. But it can help remove some of the stress of debt and also help you understand exactly what your situation is and whether it is improving or worsening.