Being stuck in a debt trap is a bad place to be. A debt trap happens when you borrow and repay but do not repay enough to pay down the interest portion of the loan, so the loan traps you in perpetual repayments.
Debt is simply front-loaded consumption. When you borrow, you are spending future cash flow today, with the intention of repaying those cashflows in future with returns to be made today. Where the proceeds of debt can be utilized and invested to yield a return larger than the actual sum borrowed, then that debt is usually classified as good debt. However, where the proceeds of the debt do not generate cash flows to repay the debt, then that debt is bad debt.
Thus, debt can be good and bad, the difference being if the economic life of the proceeds of the debt is longer in tenor than the loan itself that created the debt. However good or bad, debt is a drag on profitability.
Many borrowers fall into a debt trap because they borrow and life happened and they cannot repay, but there is also a lack of knowledge element in play and this article is focused on giving insight to the key concepts around debt, namely.
- FICO/Credit Scores
- Negative Compounding
FICO/Credit Scores: A credit score is a numerical expression of how reliable a borrower is. A credit score tells lenders how creditworthy a potential borrower is. Credit scores track payment history and numbers of inquiries to mention a few and are used to determine not only if a loan is granted but at what interest rate. A borrower with a higher credit score means the borrower is more creditworthy. A lower credit score thus will mean a higher APR to the borrower.
APR is the Annual Percentage Rate of a loan. It is the rate of interest charged to borrow funds. APR is expressed as a percentage and captures all the fees and additional charges on the loan, thus providing a complete cost of a loan. When you borrow money ask the lender about the APR, not just the interest rate.
Negative Compounding is simply compounding but in reverse. Imagine you earned 10% on an investment of N10,000.0 that’s N1,000 every year. Okay, assuming you owe an investment that charged you a fee of 10% annually irrespective of returns, this means even if you make no return you still owe N1,000 a year. That N1,000 in fees is added to your original principal, so next year you are paying 10% on N11,000. This is negative amortization, where the fees are added back to your original principal.
A debt trap is usually when a borrower with a low FICO credit score applies and obtains a loan, that loan is at a higher APR which puts considerable pressure to make payments monthly, if that borrower misses any payment, a higher penalty APR and fees is charged. This increases the monthly repayment, creates a negative amortization for that compounding period and traps the borrower in a cycle of simply meeting minimum payments unable to break out and paydown the principal borrowed.
How do you get out of a debt trap? If you are owing numerous creditors, is there a method to break out and avoid fees? Yes, there is, there are two methods, the Snowball, and the Avalanche method,
Let us take, for example, John who has three credit cards as follows.
- N1,000 credit balance with 10% APR
- N2,000 credit balance with 20% APR
- N3,000 credit balance with 30% APR
The snowball method focusses on paying down the debt with the lowest amount first, to score quick wins and reduce the number of open debt positions. The advantage of this strategy is it produces quick results, the disadvantage is the lowest debt may not be the more expensive by APR.
In our example with John, using the snowball method, John will pay his minimum balance on all cards, then make an extra payment to the card with the lowest amount i.e., the N1,000.00 card. Once that card is paid, he focuses on the N2,000 card.
In the Avalanche method, the focus is paying the loan with highest APR to reduce the overall cost of carrying debt. The advantage of this is that the borrower saves money, the disadvantage is that it takes longer to close out positions.
Using same example above, John will pay minimum on all cards then focus on paying down the N3,000 card first.
So, in summary when faced with mounting debt, this is the process.
- Organize your debt. Gather all information, amount, and APR.
- Decide what strategy to use, Avalanche or Snowball?.
- Call the creditors, ask for deals on early or bulk payments.
- Create a budget and reduce spending.
Remember, in personal finance, a guaranteed way to make a positive return on your portfolio is to pay down your debt. Makes no sense to invest and earn 10% when you have debt costing you 10%.
How to invest for retirement
Planning for retirement means planning to reduce obligation in the future by investing today.
“If you plan to retire in five years what should you be doing today?” That’s a question I got last week, and talking with the client, a lot came up which I have decided to share.
First off, What is retirement?
Nigeria’s public service has an official retirement age of 60 or thirty-five years of unbroken active working service, but in financial planning, retirement is a financial, not a chronological event. Retirement can occur when your passive income can meet your non-discretionary expenses.
You start to plan for retirement the day you start to earn an income. Your retirement plan will centre on how to generate passive income and reduce expenses. In Financial Planning, Four distinct stages are usually described in a so-called Lifecycle Chart. These are the Accumulation, Consolidation, Spending, and Gifting stages. Chart 1. Financial LifeCycle seeks to segment investing priorities, recommended asset allocation, and risk profile in a chronological timeline as the person gets older. I will take each of these stages and explain how they are linked to your retirement plan.
Chart: Financial Life Cycle
Early years: Use Your Time and Make Money, (Accumulate)
The first stage is called the Accumulation stage. Imagine a 22-year-old who has just graduated and is a management trainee. He typically has a low credit score and assets and income are also substantially lower. What he has in abundance is time. So it’s important to deploy his time in the best way to make money. Hence in the accumulate stage, the goal is to generate cash flow either from a job, multiple jobs, working longer hours, saving, cutting unnecessary expenses, etc.
The key measure in the accumulation stage is the Savings Rate which is essentially how much of income earned or generated has not been spent. On average, the participants in the accumulation stage have fewer dependents and maintenance needs which should theoretically make it easier to save.
Mid Years Use Your Money To Buy Assets (Consolidation)
In the consolidation stage the focus shifts from saving to investing. At this stage, the income earned and credit scores have improved. This is when the talk of buying a home or starting a business takes concrete shape because, at this stage, those dreams can be funded. Hence capacity to take on debt is improved, and debt is used to invest in assets like a home. Remember debt is simply front-loaded consumption, which means we are taking our future income to invest today, intending to repay with future income generated from today investment.
The key measure in the consolidation stage is the Rate of Return which is essentially how much has been generated from the investments made.
Spending & Gifting Phase; Use Your Assets To Generate Cash Flow and Time (Spending and Gifting)
Why is it called the spending phase? Because that’s what the individual is doing, spending down accumulated investments. The spending will include buying annuities or perhaps relocating to another city, your dependant’s college needs, etc. At this stage, typically very few are still earning “new” income but are rather spending from the return of prior investments.
The key measure in the spending stage is the Withdrawal Rate which is essentially how much of investment can be withdrawn as cash annually to ensure we do not outlive our investments.
Retirement is All About Passive Income
Passive income, which is the income we are making from investing from the accumulation and consolidation stage is now sufficient to generate income and reduce expenses to meet our expenses in the spending/gifting stage.
To give an example, assume we took a mortgage to buy a house in the Consolidation Stage, in the Spending stage, we pay no rent, thus we save cash, which reduces our Non-Discretionary Expenses. In essence, retirement is planning to eliminate your future expenses to the point where you need less income when you retire.
What Should You Invest In Before Retirement Or In Retirement?
Our objective is simple, Income. In retirement, we invest solely to make income to meet our spending needs, Risk profile is also very low because there are fewer recovery options if your investments sink.
The retirement portfolio is an income-generating portfolio that will be overweight in fixed income products. First, determine what the risk-free rate is. In Nigeria, we can take the yield on a ten-year FGN bond as a guide, this means we can have a target of 10% as our huddle rate for the long term. Thus I will recommend an 80/20 portfolio with 80% going to Fixed Income consisting of long term bonds, REITs, and other top-grade commercial paper.
However what happens if we lock in our funds for 10 years at 10% and rates jump to 20%, meaning a loss to our portfolio. To avoid this risk we can create a bond ladder, where we break down the bulk sum and duration of our total bond investment outlay. Let us assume we have N10m in cash to invest, instead of one single lot investment of N10m, we split into 5 equal investments of N2m and place for 6, 7, 8, 9, and ten-year maturities. This means by the 5th year the first N2m will mature, if rates are higher, reinvest, if rates have fallen then reevaluate.
What about Equities
Yes, equities also pay a dividend. In buying equities, we must ensure we are only buying stocks that pay a dividend above our huddle rate of 10% which is the 10-year FGN bond rate. Which Nigerian stock meet that huddle rate?
- GT bank
- United cap
In closing, let us summarize. Retirement is not chronological age. The event occurs when our passive income pays our bills. Planning for retirement means planning to reduce obligation in the future by investing today. Investing in retirement is income-based with a huddle.
Steps to take to bag international scholarships
Here are the steps you should take if interested in pursuing international scholarships.
Studying abroad gives you exposure among many other things, and that is precisely why many Nigerians have been looking for ways to study abroad. However, not everybody is privileged with the resources to study overseas and this is where the international scholarship option comes in.
If you are interested in studying abroad and don’t have enough funds, you should consider applying for international scholarships. This article lists the steps you can take to bag international scholarships but before delving into that, here are some types of scholarships available to you as an international student:
- Location-based scholarships
- Course or program-based scholarships
- Sports-related scholarships
- Research-based scholarships
- University-funded scholarships
- Organization-funded scholarships
- Government-funded scholarships
Having discovered the types of international scholarships available to you, here are the steps you should take to bag any of these international scholarships.
Research: Research is vital if you don’t want to miss out on good opportunities or make mistakes during your application. Research scholarship opportunities available in your prospective college or location and be on the lookout for hidden scholarships.
Check your eligibility: Having done thorough research and discovered the available scholarship opportunities, check to see if you are eligible for them. Many international scholarships have their criteria and requirement, so you should confirm that you are the right fit first.
Get the required documents: After confirming your eligibility, you should get the necessary documents. If the scholarship requires you to write an exam, prepare for the exam, write a good statement of purpose and prepare all other documents.
Start your admission process: Some international scholarships require that you start your admission process and probably get the admission before starting your scholarship application.
Contact past scholarship winners: You might want to contact the previous scholarship winners to know what they did right and how you can learn from them.
Apply for the available scholarships: The last step is to apply to every available scholarship.
The best way to get funds for your undergraduate, postgraduate, or PhD pursuits abroad is by applying for international scholarships. If you do thorough research, you can find fully funded scholarships that won’t require you to pay any amount. One of the essential steps to getting an international scholarship as a Nigerian is staying abreast of current information and this will require you to network with others.
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