Avoiding the debt trap

Australia’s household debt has never been higher, putting many at greater risk as market conditions change. If you need to ease the squeeze, it’s time to start planning now.

Debt can turbocharge wealth, but it also brings risk. Managing it is a delicate balance. For many people, the weight of their debt is tipping the scales towards dangerous territory. “We’re in a debt trap,” Stephen Kinsella, senior lecturer in economics University of Limerick (UK), told an audience at a recent superannuation conference. “Every advanced economy has too much debt.

We can kick the can down the road with lower interest rates and we have – we’ve kicked it so hard and so far it’s unlikely there’s a can left.” When it comes to kicking that can, Australians are world leaders. Household debt is among the highest in the world, equal to a record 188.4% of annual household income, according to RBA data. The bulk of that debt is in residential property, with a five-year east coast boom nearly doubling prices and encouraging an investor frenzy, which is only now showing signs of cooling.

For many long-term homeowners, it has increased their wealth. However, many others have been locked out of the housing market, will retire with mortgage debt they never envisioned, or have taken on extra debt by lending money to adult children so they can also buy a home.
Why is this happening, and how can we reverse this trend and get a handle on our debt?

Hope for the best but plan for the worst

When taking out a mortgage, plan for periods where you are unable to work, whether that’s due to family commitments, illness, or unemployment. Consider income protection insurance as a way to lower your risk. Don’t rely on banks as a guide to how much you can borrow – their internal metrics can be based on a much lower standard of living than most people are prepared to accept.
Build in the impact of potential interest rate rises over the life of your loan – ASIC suggests considering a 2% rise, however with rates at historic lows it may be wise to be more cautious.

How we got into
this situation

Sydney has become one of the most expensive places in the world to live – the median dwelling price of almost $900,000 hasn’t helped matters. However, there are also reasons behind those high property prices, apart from record low interest rates which have encouraged borrowing.
Reserve Bank of Australia governor Philip Lowe told a recent government committee that strong population growth, zoning regulations stopping over-development and inadequate transport have all provided a strong tailwind.

“If you asked anyone how a country would deliver high housing prices, you’d find we’ve made all those choices: live in fantastic coastal cities (most of us); underinvest in transport; have a liberal financial system; and not want high density. We’ve done all that, so there are high housing prices and this interaction between housing prices and debt.”

The result is the average household mortgage debt-to-income ratio has risen from around 120% in 2012 to around 140% at the end of 2017. It’s a clear danger sign although there have been few signs of mortgage stress so far as economic conditions remain benign. The latest Household, Income and Labour Dynamics in Australia (HILDA) survey shows that 75% of households with owner-occupier debt had mortgage payments of 30% or less of income – a rough indicator of the limit for a sustainable level of mortgage repayments. That still leaves onequarter pushing the limits.

Don’t wait until it’s too late

Excess debt isn’t just bad for your financial wellbeing, it can be hazardous to your health.

A broad UK survey of mental health in 2012 found that people in excess debt had stress levels comparable to those who had been in a war – findings which have been backed up in other studies. “There’s a deep psychological damage that goes along with being in excess debt,” Kinsella said at the conference.

However, there are ways to avoid falling into the debt trap:

Be realistic before you buy

Consider the long-term behaviour of assets such as residential property before making a significant financial commitment.
Few assets post significant price rises year-in, year-out. For example, many home owners in Western Australia bought during the mining boom when prices were quickly climbing – and were burned when they then fell with the end of the mining boom. Many east coast property investors have become caught up in recent rapid price rises but ignore the years following the global financial crisis when property prices remained largely flat.

Understand what you spend

To set a budget that you can stick to, you need to understand how much you spend. ASIC deputy chair, Peter Kell, says
that most of us underestimate our actual expenditure.
Monitor how your cashflow moves during the month, and build in a buffer to allow for unforeseen costs such as car repairs or replacing major appliances. The National Debt Helpline suggests allowing an extra 10% for rainy day expenses. If you’re already concerned about your debt levels, it’s best to seek help early.
A financial plan accompanied by easyto-use budgeting tools and personal coaching can pave the way to paying down debt or restructuring it more effectively.

Your adviser can help you manage debt and build a realistic plan for the future. Contact our office today.