A high return in a low-rate world

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Sitting at 0.75 per cent, Australia’s official cash rate is at its lowest in recorded history. This follows the Reserve Bank of Australia’s (RBA) attempt to stimulate the flagging economy and counter rising unemployment numbers.

The rate cut may result in lower interest rates and give you a breather with reduced debt repayments. But here are a few things to consider before celebrating your unexpected windfall and keeping the extra cash in your pocket.

Firstly, banks do not always pass lower rates to their customers, so a reduction in the cash rate may not trim your interest costs. This is also a good time to assess if you’re getting the lowest interest rates possible and if not, you should probably shop around for a better offer with another bank. That said, don’t forget to check the terms and conditions of your existing loan, and whether you will be subject to hefty early repayment or break fees, before signing on to a new loan.

Secondly, establish if your debt is deductible or non-deductible. Debt from credit cards, car loans, personal loans and mortgages on your principal place of residence are typically classed as non-deductible debt. But if your loan enables you to produce taxable income, the interest on it can be claimed as a tax deduction. Such loans, defined as deductible debts, usually come in the form of loans used to buy a business, investment properties or shares. In pre-tax terms, non-deductible debt is more expensive than deductible debt, and should be paid off as quickly as possible.

Other things to consider:

  • Sticking to your previous payment amounts – by sticking to your pre-interest rate cut repayment amount, you could save more in interest and even pay back your loan earlier than anticipated. Using a calculator to find out how much money and time you will save might motivate you to stick to your current repayment schedule.

  • Pay more than the minimum on your credit cards – credit card interest rates range from about 10 per cent to well over 20 per cent. Even at 10 per cent, a $1,000 purchase would cost $1,299 in principal and interest over 5 years and five months if you made only the minimum payment, according to this ASIC calculator. By doubling the repayment to $46 each month, you’d only pay $1,098 over two years. At a higher rate of 19 per cent, you would pay $1,994 in principal and interest over more than 8 years and nearly double the cost of your purchase.

  • Consider consolidation – debt has a way of growing on its own, especially when high interest rates continue to compound. Consolidating your debt to a single loan with a lower interest rate could be an option, but it requires careful attention to the terms of any new loans. You can learn more about consolidating debts with this ASIC guide.

So, how do you pay off debt?

Start by listing all your loans, including balances, minimum payments and interest rates. Your list might look something like this:

  • Credit-card debt

  • Car loans

  • Any buy now/pay later liabilities

  • Student debt

We have left mortgages off the list because other debts often have higher rates. Also, shelter is a necessary expense, so borrowing money to pay for it, within reason, can make sense.

Once you have your list, analyse which of these approaches will give you the best chance of reducing your debt:

  • The debt avalanche method – with this approach, you direct as much money as you can toward paying off the loan with the highest rate first. Once that is paid off, apply your savings to the debt with the second-highest rate, and continue in this way until you are debt-free. This method will save you the most money. But clearly requires the biggest commitment/discipline.

  • The debt snowball method – with this approach, you pay off the smallest loan first, regardless of the interest rate. Once that is paid off, add the amount you no longer need to pay on that debt to the second-smallest loan. Work your way through your debts from the smallest balance to the largest, until you have paid them all off. This approach may offer quick success that can motivate you to continue and keep you motivated to achieve debt-free status.

Regardless of which approach you take, it’s important to make at least the minimum repayments on all of your debts to avoid any additional fees.

Need a little inspiration to get started? Put your numbers into this ASIC credit-card calculator to see how much reducing your debt can add to your net worth, and if you need help controlling your debt, consider the options in this ASIC article.

Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.

Source : Vanguard

Reproduced with permission of Vanguard Investments Australia Ltd

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer. We have not taken yours and your clients’ circumstances into account when preparing this material so it may not be applicable to the particular situation you are considering. You should consider your circumstances and our Product Disclosure Statement (PDS) or Prospectus before making any investment decision. You can access our PDS or Prospectus online or by calling us. This material was prepared in good faith and we accept no liability for any errors or omissions. Past performance is not an indication of future performance.

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