How you can avoid debt and how the snowball principle can help you get debt under control.
You might think it couldn't happen to you, you already have a safety net in place! But something unforeseen could quickly place you in the debt trap. COVID-19 has done just this for many women. Throughout 2020, we interviewed for a few roles at SmartPurse, and most stories were the same: redundancy, state benefits, barely scraping by...
So many jobs have disappeared, and from such unexpected sectors. Travel has been decimated, event companies have downsized, and many small businesses have closed their doors for good.
Unfortunately, the pandemic didn't force everyone into debt. They were already there, or living paycheck-to-paycheck. COVID-19 simply exacerbated the problem.
How much average debt does the UK citizen have?
As of January 2020 the most common types of debt in the UK are personal loans, student loans, hire purchase and credit cards. Debt in the UK looks like this:
- Average total debt per household = £60,363
- Average credit card debt per household = £2,595
- Total unsecured debt per adult = £4,264
What are the 9 main reasons someone goes into debt and struggles to get out?
Income can often disappear quickly, but the cost of living remains the same, at least at the beginning. In January 2020, UK unemployment was at 3.9%. By November 2020, largely due to the impact of COVID-19, it had reached 5%.
When you separate from your partner, the increased cost of rent, living expenses, and potentially legal advice, can all come as a shock. Plus, old debts continue to rack up, and it can take a while before you receive any alimony or other agreed upon payments.
Illness/stroke of fate:
In the event of accident, illness or death, you should have access to the funds and treatments you need in the UK. This is in comparison to, for example, the US, where help depends on your health insurance.
Overdraft/credit card overdraft:
This is one of the most expensive types of debt - if at all possible, simply avoid it or immediately make a plan to pay it back; otherwise the mountain of debt will continue to grow exponentially.
Buying on loans/instalment credits/short loans:
High-interest costs and processing costs occur, and in the case of car leasing, higher risk protection is also required. It is best to calculate the total price in advance, how much the purchase really costs and how the loan makes it even more expensive.
Shopping spree/online purchases:
It's easy to lose track of online purchases, especially when using a credit card. Make sure to check your card statements regularly, and as well as keeping a strict budget, save things away in your basket rather than immediately buying them. See if you still want the item after a few days have passed.
Unfavourable tariffs, small expenses such as in-app purchases which are becoming more and more common, subscriptions which are no longer needed, data roaming at home and abroad, but also call charges. Especially for young people with lower incomes, the mobile phone can become a debt trap. Choose a subscription according to your needs, "clean" your mobile phone regularly from unused subscriptions, and automatically limit roaming abroad.
Rental costs are high. If you suddenly find yourself living in a flat that you can no longer afford, you're locked into your rental contract. It helps to first calculate costs compared to income and plan for the worst-case scenario. As a rule of thumb, rent, including service charges, should not exceed one-third of your income. That's hard to achieve in big towns and cities!
Real estate financing:
It's not hard to over/underestimate interest, maintenance, additional payments, legal fees, or refurbishment costs. And then it all becomes confusing quickly. This is where sufficient private equity and a very conservative calculation of maintenance and interest is helpful. Make sure to have legal protection insurance for possible legal disputes.
Avoiding the debt trap
Of course, life happens - you can't avoid illness, job loss, or the breakdown of a relationship.
In theory 'don't spend more than you actually get' is a pretty simple mantra to live by. But in reality, it's not always possible. It's more realistic to plan for money changing life events, having a budget (and sticking to it), as well as a nest egg, can save you from the debt trap - or at least hold it off long enough to find a solution.
- Budget: Over the past few months, our lives, and to some extent, our consumer behaviour, has changed — less general spending, but more online purchases. Maybe you have just as much, less or even more money available now because many daily activities have fallen away. If you don't have one, set up a budget. For everyone else, now is an excellent time to adjust your budget. Be sure to include the nest egg and, if necessary, debt repayment — Excel, e-banking, apps or various templates perfect for money planning.
- Nest egg: The perfect nest egg contains 3-6 months of your after-tax salary. Starting now is highly recommended, no one knows how long these uncertain times will last. Start off small, putting a little away each month to pay your future self, it'll be worth it in the long run - raising money when you need it urgently is often tricky and expensive.
Use the snowball principle to get out of debt faster!
One of the fastest methods of paying back debts is the snowball principle. Here's how it works: You give the highest priority to accounts with smaller amounts instead of those with the highest interest rates.
- List all debts, from the smallest to the largest;
- Pay the minimum of the rates you have to pay, except the smallest debt;
- Pay off the smallest debt as quickly as possible;
- The next smallest debt at the top of the list, pay it off, repeat until everything is paid.
Why does it work? Harvard researchers have found that the motivation and behavioural change that comes from successfully paying off small debts is so significant that you reliably pay off all your debts much faster, like a snowball that gets bigger and bigger.
If the Snowball Method doesn't sound right for you, have you heard of the Avalanche Method? We compare the two methods in our Digital Money School, so that you have all the information you need to choose the method that works for you!
Once you’ve calculated your current total worth, subtracting your expenses from your income, it’s time to think about your liabili...