How To Plan Ahead To Use Debt To Create Wealth

Aug 14, 2019 | Personal Finance

In July, this blog discussed making debt your friend by using it to your advantage and by strategically investing in shares rather than reducing your mortgage. Another angle to the strategy of using debt to create wealth is to plan for changes in your circumstances before you begin so you don’t get caught short.

Some changes you might see coming: perhaps you expect to replace your car in the next five years, take a big holiday, or begin a family. Some changes, like interest rate changes, job loss, economic downturn, serious health issues and death, can throw an unexpected spanner into your well-oiled works.

However expected or not these challenges are, good planning can integrate and mitigate their effects – and that planning needs to happen now because if you wait until the crisis hits, it’s too late.

Dennis Harman of US-based Zacks points out that “Each household’s contingency planning and budgeting is different”: one size for calculating your contingency plans definitely does not fit all. However, everyone can consider and tailor the basics to their own situation.

The Buffer Zone

To determine whether you can afford to borrow, and how much, you first need to determine how much surplus cash you regularly save. If you only save $100 a month, you only have capacity for a very small loan, and very little wriggle room should something go wrong and you’ve already pledged that sum to loan repayments.

Ensuring you have solid savings, however, gives you breathing space should a crisis come. Ideally, you should have 3-6 months’ worth of your expenses saved. That could mean anything from $30,000 to $60,000, depending on your level of income and recurring expenses. Mywealthsolutions refers to this as the personal burn rate

It’s a high savings goal to set but if you consider it a target rather than a requirement, it gets easier to achieve. You only need to have access to those funds, rather than a cash reserve of that amount – you might have it accessible in a home loan redraw, an unused line of credit or other assets that can be liquidated quickly. Start setting up your buffer now – if you wait until your income falls, it will be too late.

Interest Rate Changes

You’ll have your investment debt for an average of 5-10 years, so you should plan for rate increases over the period. We might not know when rates will change, but change they will. You can build in some flexibility by using the banks’ own forecasts.

While some interest rates are currently as low as 3.5%, a longer-term view is offered by the banks’ 5-year fixed term rate, which is at around 5%. Plan using that longer-term rate and you’ll be ready to meet any rate rises; while if rates stay the same or drop, you’ll have that much more sitting in your 6-month buffer.

Insurance

However stable your income may appear, your circumstances can change abruptly. A sagging economy might chip away at your monthly income or you may lose your job entirely. Serious illness or death may leave you and your family unexpectedly vulnerable to the loss of your greatest asset – your ability to earn an income.

The first contingency plan here, obviously, is to take care of your physical and mental wellbeing and to not put off visits to your doctor. Maintain your health as you’d maintain any other asset.

However, accidents and illness still happen despite the best preventative measures. Ensure you’ve invested in both life and disability insurance so that, whatever happens, your family is cared for.

Revising Your Contingency Plan

You can’t just devise a plan and then ignore it until next year, because change, as they say, is the only constant. Revisit your plan more frequently, particularly when interest rates, the economy and your personal and family life are changing, to be sure your contingency plan still offers you the best protection.

The Savings Habit

Rather than developing a budget, which most people don’t like and won’t stick to anyway, a more practical approach is to begin a savings habit. Sock away a regular amount each payday and don’t touch it – you’ll soon work out if you have more to spare or if it’s too much, and adjust your spending habits (or savings habits) accordingly. 

<a href="https://ugc.net.au/author/louis/" target="_self">Louis van Coppenhagen</a>

Louis van Coppenhagen

Louis is a Financial Adviser with 15 years experience, three university degrees and specialist qualification in Aged Care.

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