Categories
Financial Planning Germany financial products Post

Guide to Income tax in Germany

I have been asked to write about personal income taxes in Germany and the German tax system a few times. Things get complicated with taxes when you are an immigrant, like an NRI from India with income in India and work in Germany. How do you then pay taxes in Germany and file tax returns? Do you hire a German tax consultant or do it yourself? Lets try to break it down to the basics.

pile of american banknotes and retro light box
Photo by Karolina Grabowska on Pexels.com

Tax Rates in Germany (2020)

Germany has a concept of progressive taxation, simply put the tax rates go upwards the higher your income is.

Income (Single)Income (Couples)Tax Rate
Less than 9,408 eurosLess than 18,816 euros0%
9,409 – 57,051 euros18,817 – 114,102 euros14%
570,52 – 270,500 euros114,103 – 541,000 euros42%
More than 270,000 eurosMore than 541,000 euros45%
Income tax rates Germany 2020

As a couple, the tax limits are doubled because taxes are calculated as a household. This tax rate is not complete it inself, apart from this your payslips will also have entries of Kirche Tax(Church Tax 8-9%) and Soli(Solidarity Surcharge at 5.5%).

Other Essential Charges which aren’t Tax

Apart from the tax payments each month, you also pay for Health Insurance (Krankenversicherung), Pension Insurance (Rentenversicherung), Disability and Unemployment Insurance (Pflegeversicherung & Arbeitlosenversicherung). The impact of all these payments is on your take home pay (nettolohn) which dwarfs when compared to your gross pay(bruttolohn).

So, how do you optimize your tax payments such that your take home pay isn’t tiny?

Tax Classes in Germany

Enter Tax Classes. If there is a concept which I have seen people confused with, it is the selection of tax classes. So here are two key principles to understand:

Principle #1: A tax class does not change your overall tax due to Finanzamt for a given year, that number is calculated based on your income level and applicable tax rate.

Principle #2: A tax class only changes your tax prepaid each monthto Finanzamt. So if you pick aggressive tax class, you get lower payslip now and a higher tax return at the end of the year. If you choose to pay too little tax now, the payslip is higher but at the end of the year you might have to pay back to Finanzamt.

  • Class I = single/separated
  • Class II = single parent
  • Class III = married and spouse has no income or lower income
  • Class IV = married and similar income to spouse
  • Class V = opposite of class III, i.e. this is the class your lower earning spouse has if you have III
  • Class VI= Employees who receive income from other employment

Most of the time classes are allocated by default, it is usually the Class III/V combination or Class IV where there is some choice to be made.

International Income and Double Taxation

If you have invested in your home country, then what is the impact on taxes? The answer to this is to first check if there is a Double Taxation Agreement between Germany and your country (you can see this here). The goal of such an agreement is to reduce taxes to be paid on the income earned, so that you do not end up paying taxes in both countries.

DTAA means you do declare your income from all sources in Germany and will get reductions in taxes in either Germany or your country. The actual rules will be as per the agreement and might need more digging into.

Now I can speak a little more for Indians living in Germany who have investments in India, you need to read this link.

Filing tax returns

You are supposed to file tax returns for the current year in the next year July 31. For example; for 2020 you should file returns by July 31, 2021

Tax returns are allowed retroactively, for the very first time, for upto 4 years. Finally, returns are made to a tool called as ELSTER.

You can choose to use software tools like wundertax, steuergo or have a tax consultant help you.

It takes a few weeks to get confirmation from Finanzamt, and the amount is usually transferred by the time you get your confirmation. In case of discrepancies, Finanzamt can ask you to submit more proofs.

Who needs to file tax returns?

If your income was more than minimum levels (above) in the year and if

  • There is income in another country during the financial year for you
  • You are married and one spouse has opted for tax class (Steuerklasse) III or V
  • The tax office (Finanzamt) has granted you an allowance (Freibetrag) on the employment tax statement.
  • There is income or benefits like parental or maternity leave payments.
  • You have received extraordinary income, such as severance payments for which your employer retained employment tax.
  • You have more than one employer at the same time (excluding mini-jobs).

Do you have more questions on Income tax in Germany? If yes, please leave a comment.

Categories
Post Rant

Money is not evil

A few months ago I had talked about my relationship with Money and how it has shaped my behaviour. Today I will ask you to think about why is money is not evil, and it brings access.

Money the root of all evil?

Before we proceed, pause for a second and try answering: What do you feel about money? Keep the answer to yourself before reading on.

Money is behind all the Corruption in the world

Most people would consider that all the corruption in the world is because of Money. If this money would magically disappear, the world might be a nicer place.

This is only partially true, sure unethical pursuit of money will account for most corruption and wrongdoings and yet, eliminating money will not change it. It is the battle between ‘having wealth‘ and ‘not having wealth‘ is what really will still continue in one way or another. Money is just an easy way to represent value of things / objects / services. We rely on an exchange of goods and services, and till the time some people own a resource in scarcity, they will hold power and others will covet it.

If I pursue money, I am selfish and self centered

If you are like me, you might have that thought too. For a very long time, I have had this notion that if I am going after higher income or chasing money then it is a bad trait. All because, money is evil right?

The fact is, this is not true, just because you want a better worth of your efforts and believe that your skills / business have a higher value, there is nothing wrong in chasing it. Millions of businesses fight between being cheaper to customer and others attempting giving higher but expensive quality. None of those are wrong ideas, the value of product often will represent the quality. It is not a zero sum game, that to win someone else must lose.

Your employer is renting your time to get things done, so if you think your time is worth more you must demand a better price.

The pursuit of Money will change my relationships with people

Now I really explored this from a scientific end and there is some evidence that the richer people get, the less compassionate they become. If your relationships change, they might actually need a rethink and you also need to think about your value system. However, there is a big element of what money really brings when you become rich.

Money brings access and gives you voice

The real fact is that inspite of all the democratic talk of us all having an equal say, the world does not work like that. The real strength which money brings is access and freedom. It also gives you a voice on the table where the big decisions are made.

The first step to get that access and have a voice is to earn more and grow more money. There isn’t another way.

Money is still just a store of value, and yet it gives you the power to bring change. Now, if its abused then Money is evil and if its used for good, then Money is not evil. I’d so, pursuit of money is not evil so long as you remain ethical about it.

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Personal Post

Announcing Money First and free Book Giveaway

2020 has been a strange year, of many firsts for all of us. Here’s my big first time project: Writing a book! It is called MONEY FIRST, and I am very excited to share it with you!

My book will answer questions like,

  • How does banking work in Germany, how can I save on bank fees?
  • What is SCHUFA, how do I get a free SCHUFA report, how do I maintain a good score?
  • How do personal income taxes work in Germany?
  • Which insurances should I buy in Germany?
  • How do I invest money in Germany? What is a Depot, Sparplan? How do I manage taxes on capital gains?

Free Giveaway

I am giving away the first chapter for free! Just click on this link Money First Book – Free Giveaway

SIGN UP with your email, and I will send the chapter to you.

ONE REQUEST: I would love feedback from you, on the content, on what questions would you want me to answer in the next chapters.

YOU, ARE THE INSPIRATION to keep me going.

Categories
Financial Planning Post

The only money principles you need to follow

person in yellow coat standing on top of hill
The road to financial freedom

I have been quiet for the past few weeks, its for the lack of ideas and lack of structure in my life which kept me away. I went back to evaluate where my life was and where I need to be. This led me to write this post on the only money principles you need to follow. As things proceed in life, I will update this again. A lot of this is obvious, but foundational!

Principle #1 : Spend less than you make

Yes, this is obvious but it is the very first step. If you are not able to consistently spend less than what you make, you are sooner or later preparing yourself for a bad situation. The key word here is consistency and not I save when I can.

Principle #2: Plan your big expenses in advance

I am not a big believer in budgets, some people are and its great for them. Instead, I like to plan for my big purchases, this means holiday trips, gifts and other things which can easily derail my monthly savings (and cause frustration). I was able to even plan ahead for the first 6 months of our baby and save accordingly.

Some might tell you to use the envelope method, and that is great too. The point is, discipline and adherence to savings happens when you already structure your spending. The technique of getting there is upto you.

Principle #3: Pay yourself first / Save before you spend

Your first spending with the exception of life essentials like rent, electricity and commute, should be for your savings. Whatever is left after that is what you need to make do with that month.

Principle #4: Understand finance basics

It is quite surprising to know when people do not understand concepts like depreciation, compounding, inflation and opportunity cost. If you do not know them well enough, educate yourself.

Principle #5: Be intentional in your life

This is my biggest money life advice, you do not need to be a hermit to be financially free, but you do need intention in every significant action of your life. Need a car? Great, plan for it, find the best car which fits your needs (and not your ability to pay). Need a house? Sure, why not, but refrain from buying a house which chains you for next 3 decades.

Do not rationalize bad money decisions

Mr A

Start understanding the difference between your needs and wants, and make every action you take on what value it shall bring to your life.

Principle #6: Pick a steady portfolio, automate your investments.

I know many people who are into trading stocks, they want to invest into big potential stocks and sell them at a profit with a short term goal. This is beyond my skill level. I do hold a few select stocks like AAPL, MSFT, BRK or AMZN but all these with a long term hold perspective of atleast a few years.

Unless you have deep knowledge and ability to stomach the risk, you should simply invest into Index Funds / ETFs as a start. I recommend picking ETFs which have low maintenance fees and coverage of an overall market. You might also want to put 10-20% of your savings into bond index funds. My preferred ETF today is A1JX52, you can research more on JustETF.com. The point is, for most of us amateurs, a select portfolio is good enough. If you do this for enough years and without cheating, you may end up being very safe.

Automate everything! If you have a select portfolio, just go to your depot account and setup a sparplan to invest on a fixed date each month into your handpicked choices.. Today all my ETF purchases and even some of my long term stock purchases happen via sparplan.

Principle #7: Stabilize your expenses and find your safety number

If you have made to Principle #7, well done! Once other things are happening as a well oiled machine, its time to think about the future.

Wouldn’t it be great if a risk to your job would not stress you out? What is that number which makes you not worry of sudden life events?

To do this, find your monthly expenses minus any big splurges and multiple it with the number of comfort months you need.

So, if you need 2000 EUR x 12 months = 24,000 EUR is your safety number to survive for an year without a worry in the world.

white and black number 11
Principle #8: Do not obsess over money everyday, let this not consume your life!

Money is a means to an end, an essential one at that. Yet, money does not need to be the only thought in your mind unless you are struggling. Find your own meaning, spread love to your family and friends, do your own thing. There there are many life pursuits which are priceless (I sound like a Mastercard commercial!), find that passion!

This also means, do not peek into the bank account or depot account status everyday, specially when your goals are long term!

So those are my 8 money principles, if you think there is something which is worthwhile and missing, give me a shout out in the comments section!

Categories
Financial Planning Germany financial products Pension Schemes Post

What is Rürup or Basis Rente?

Basis Rente

I am kicking off a new series on financial topics used in Germany. The first financial product that I would like to talk about is Rürup or Basis Rente (Rente in German means pension). We also explore common terms and their meaning to build up the concept of Rürup.

Concept #1: What is altersvorsorge and Gesetzliche rentenversicherung?

Altervorsorge (old age provision) is a general term used to describe various products and options which are available to support you for your old age. These are usually described into three pillars (or categories):

  • Basisvorsorge (basic provision) : This includes statutory pension insurance (also called gesetzliche rentenversicherung) scheme from the German state, and other products like Rürup . The products are usually tax efficient and are design to work as a pension should.
  • Privat vorsorge (private provision) : This is a private measure, people can use products in this category to top-up their Basic provision. This will include products like Employer pension, Reisterrente or Directfonds. There is usually some subsidy available.
  • Ungeförderte Private Vorsorge (unsubsidized prevention) : This is also a private measure usually focused on Lebensversicherung (Life insurance) products. It can also include products which offer pension with a life insurance.

Now, this post only focuses on Rürup , and I reserve some of the other topics for more posts in this series.

The question of Rürup Rente. Where does it fit in retirement planning

Rürup is a self invested pension scheme, this is well positioned for freelancers who may not be invested in the statutory pension program. At the same time it is also a choice for those who have statutory pension but want to top that with additional pension.

Rürup pension is named after Bert Rürup who is an economist and a politician. His focus was on pension reform and this pension scheme was launched in 2005 named after him. It is also often referred as Basis Rente

Why is this relevant as a top-up? The simple answer is that statutory pension payouts may not be sufficient to help you survive in old age. It is predicted that only around 48% of your last paid income will be your statutory pension (*the actual calculation is more complex). So Rürup is a way to supplement your pension and avoid

Key features of a Rürup pension program

  • Behaves like a pension, you cannot withdraw this in advance and it is only paid as a pension after retirement. You cannot exit a Rürup but stop paying into it.
  • There is no minimum contribution limit. Contributions can be stopped, this is helpful for freelancers.
  • As it is a pure pension plan, it also gives you tax benefits. Upto 24,900 EUR investment are tax free.
  • It cannot be transferred to another person, loaned against or inherited. It can be setup to get paid to your immediate dependent (spouse) or children if <25 years upon death.
  • It is designed to save taxes if you have a lot of tax liability, upto 100% tax rebate during accumulation from 2025
  • Pension will be taxable as per prevailing rules in future.
  • It is possible usually to change providers, but there can be fees.
  • Two versions usually exist: Fixed classic pension and Unit linked Pension
  • Fixed Classic pension has returns around 1.25%, while Unit Linked is linked to market performance.
  • Expense costs are high, between 3-6% annually.

Should I take a Rürup / Basis Rente?

This is a very debatable topic. Lets make it clear, if you are an immigrant and may move out of Germany, you will still get paid out but will need forwarding address. It might just add more hassle.

Having said that, many complain (and rightfully so), that Rürup has very small returns and when costs are considered the value of tax benefits is only realized when you are 70+ or something.

At the same time, you can think of Rürup as a bond investment, which is about capital preservation and not exactly about big returns. This is at the cost of losing access to capital, low returns and potentially high maintenance expenses.

Will Mr A invest in this?

No, I think I can potentially get better returns with index funds/ETFs and lower costs. I might think of it during the consolidation phase of retirement planning when capital protection is a goal.

Categories
Personal Post

Corona forced us to learn from our money habits.

The Corona crisis has upended our lives, suddenly a trip to the grocery store is the biggest outing of my week. Everyone’s facebook and instagram timelines are more like #latergram and no projections of great lives. Instead its all about survival, and waiting it out. The crisis has also led us to evaluating our money habits and look at what really matters.

If you have not looked into your money habits, and have some time at hand, it is a good time to try it. I will suggest a few things at the end of this post, jump through if you are in a rush.

Now, lets look at our money habits:

Lesson #1 : We ate out more than we realized, and it was affecting my health.

nom nom!

We used to believe that we only ate out 3-4 times each month, when we go out as a family to a restaurant. Its our escape and sometimes it was also a way to close a busy exhausting day. Now, even when we are often working late in the evening and struggle with childcare during the day, we make it a point to cook. The only luxury has been frozen pizza.

We had simply failed to count the coffees, croissants, ready to eat salads and on the fly noodle trips which are all less than 30 metres from our apartment. None of these are very expensive luxuries but they added up both to the bills (>150 Euros a month) and to my waistline. I lost a couple of pounds in the first weeks of the isolation.

Will we never eat out? Of course we will, its still our escape, but this financial habit needs more careful consideration.

Lesson #2 : Many Most of our purchases are non essential and not critical

Last weekend we watched The Minimalists documentary, while the lifestyle is too extreme but it has a lot of value. Our realization was that we are not as frugal as we thought ourselves to be, we have accumulated hundereds of tiny objects instead and struggle with clutter.

The result has been a clean up exercise, I have reduced my wardrobe by 30% of all clothes, and reduced the books I owned. While this new excitement is great, I am not sure if I can sustain this.

Lesson #3 : Great experiences have little to do with the price

We like to travel, 2-3 trips an year has been a normal for us, and a few day trips during summers is refreshing. We have always been careful in budgeting and booking except a few times like last year. With no option to travel on Easter, cancellation of our parents trip to Germany and no bookings in place for summers, we are home and trying to make the best of it.

A walk to the river on a sunny weekend and the ability to experience spring without the noise of cars swooshing by has been refreshing. We didn’t need to spend any money for that. I have also learnt to make peace with no trips, and we are doing fine (for now). Of course, I fully realize a walk down the riverside cannot replace a holiday, but the ability to adapt is the biggest strength of being human.

Lesson #4 : Happiness exists in tiny things each day and not in big goals.

We knew that consumption is not sustainable, but the real realization only came in during this isolation.

Spring this year is quieter and fresher.

I realize that blowing bubbles in my little balcony with my toddler is a source of happiness, or 20 Euros worth of sand is enough to give him a feel of a playground right in that balcony.

I also learnt that things which I used to think what a family man should provide like cars or house with a garden do not matter to my family. In the long run, those things might be useful, may even be a measure of success to some, but are NOT a measure of happiness. This money habit of comparing myself with others, has to stop.

Lesson #5 : Fear is a great motivator to save and invest in your future

As Coronavirus has hit industries, some of my customers are struggling too. At the moment, my job seems safe, but it can all change. The result of this is two specific things I am now actively focusing on:

  • Investing in myself: I am actively learning new skills, so make myself available for more projects and also secure myself for a a shaky future. I would like to prepare for what is to come after coronavirus.
  • Counting our blessings and tightening our belts: Over the years, many people in our life questioned about why we moved to Germany. The answer rings true today, if things go awry, the German social system and the health care will be around for a while to allow us to recover. To top this, we are holding more cash than before, because these are uncertain times.

How can you evaluate your own money habits?

I have a simple list of questions you can ask yourself. I must say, your answers or goals can be very different from mine and that is fine. If money inspires you and a Tesla is your dream, so be it.

  • What are the top 3 life goals for you? (hint: Money, Relationships, Career or Health).
  • Has the isolation changed for you in terms of spending? How?
  • What is the one thing financially, which you are not able to do, and it still feels fine?
  • What is the one thing in terms of spending, which you are not able to do but would like to continue?
  • How prepared are you if there is a loss of hours or job loss suddenly?
Categories
Coronavirus in Germany Financial Planning Post Rant

Surviving Job loss in Germany : Read this!

Arbeitslosigkeit durch Corona by Zeit.

It is all very convenient to write as a blogger to invest the dips, and I did this too last week! Lets get real, we are facing a very high chance of recession and job loss soon. Thus surviving job loss is a very real theme for so many of us.

Why talking about surviving job loss and income loss is important, now?

As Germany crossed 10,000 Coronavirus cases this morning, we are heading for a complete shut down.

The fact is that retail shops, travel agents, salespersons, cooks, restaurants, waiters, their suppliers, airports, airlines, ground staff, freelancers, event management companies, movie theaters, arts and many more are at severe risk of losing their jobs. Globally the picture is no different and its already starting to get ugly for some.

We are going to face millions of job losses, crushed busines demand, and misery.

Even if this virus goes away as trillion dollars pump into the market, funding for dying companies, it will take years to recover. The Dow Jones has plumetted 2000 points today(had to change this while writing!) 33% less than all time high a month ago! A MONTH AGO!

All this, within 20 working days!

Surviving job loss: Emergency fund.

Every FI blogger has talked about it. For some of us, this is already too late. If you have already lost your job, income and do not have enough to cover then you must reach out for benefits.

If you are still in your job, fear the reduction of pay or job loss, this is the time to tighten your belt. However, If you are confident to ride through, go read another post.

  • Save everything you can, be super frugal, avoid any unnecessary purchases.
  • If you can save 6 months of expenses, try 8 months, if you can do 8 months, try 10 months.
  • Were you planning a apartment purchase? Delay it.
  • If you were planning to get a car, even an old one, delay that!
  • Do not invest in the market, stay away and hold cash

Surviving job loss: Arbeitslosgeld

There is no shame in this, you have been paying into the social security for times like these. As things escalate, more people will seek this and there will be delays in handling all the capacity.

Please visit the Arbeitsagentur website (in English too). You must immediately inform them of a job loss as soon as you know have a confirmation from your employer. You can also call at +49 (0)800 4 5555 00

Please make copies of your payslips, bank statement, resume and existing job contract ready. You will need those.

Surviving job loss: Fix your living situation

The next advice is not for all, neither is something I prefer. If push comes to a shove, find a room-mate to share rent, or move in with your family.

There is a moratorium on evacuation in various states, read this!

Surviving job loss: German Governments loan scheme

Over 2.3 million people work as self employed, they are at significant risk. There is a high chance there will be a scheme to help them through a 0% loan or more.

If you are a small business or freelancer, you can get a credit loan from the German Government, you can also get tax breaks and subsidies for loss of business. Please click here to read the official guidelines.

Categories
Financial Planning Index Funds and Stocks Post

Staying sane when the Stock Market Crash has eaten your savings!

Image result for market crash

Couple of days ago I talked about Surviving Stock Market crash of 2020, the market, oil and bitcoin all are going down south. My portfolio is at -7%, 2.5 years of regular investing has vanished. It could simply go down further but it will not crush my Financial independence dreams.

How can I stay clam when the Stock Market crash has destroyed my savings?

I do not know the answer to this.

It is not easy to see our savings burn up in so quickly. It takes me several months to save up money and its not easy to see it simply burn away.

Prioritize your family’s safety first!

The Stock Market Crash was triggered by the coronavirus, this is a real health threat and we all are at risk.

Safety of your family comes first! If you are in an at-risk industry like travel, music, airports, restaurants or similar, you must first make sure that you have sufficient cash in case of a job loss or sudden medical expense is needed. This could be anywhere between 3-6 months of expenses. A Stock Market Crash often result in companies going down under, and an added threat of coronavirus will only make this harder to recover

Invest, only if you can stomach it and can stay put for a few years!

My favorite Financial independence author JH Collins wrote on his blog about the 1987 market crash and how he reacted to it. It seems to be a great idea to invest all surplus cash into the market, either through stocks or simply buying cheaper index funds.

At the same time, be aware of:

  • We don’t know what is the bottom (and when), so the stocks can continue to fall for next months (average bear markets last 4 to 11 months).
  • Companies will fail and die, so your bets might fall flat!
  • If you think recovery is quick, you might be surprised.

So, one of the ways to safeguard against the wobbly race to the bottom of the stock market crash is to invest in intervals. In case you have 2000$ to invest, instead of going all in a single day, average this out to say 100 $ per week for 20 weeks instead. This is DCA in a nutshell.

Don’t invest if…

  • You want the money back in 12-18 months
  • Your job can be at risk, be very aware
  • You are not comfortable, just don’t listen to an unknown guy’s blog post to do it if you do not believe in it.

Finally, keep calm and carry on. Sell if you feel you cannot recover at all, but before this please read this thread from 2008’s crisis! We aren’t the first ones facing this, and it isn’t the last Stock Market crash we’d see!

Categories
Financial Planning Personal Post Real Estate

Why we have to delay buying our home

I have not been a keen imitator is template dreams, I still do not own a car, and have argued against buying an apartment at home. However, recent changes in the local European interest rates, changes in life situation and simply higher rents made me start believing that we could own a home. However, recent events have just made us decide that we have to delay buying our home.

For Sale

Why buy when you could have rented Mr A?

True. We tried and are failing.

After becoming a parent, the limitations of the space in our current rented apartment and the struggle of our visiting parents climbing 3 flights of stairs made us search for a bigger rented apartment.

Yet, with the constant struggle of applying and never being called to visit, and the few instances when we did get to visit homes, we are facing an uphill challenge where a bare increase of 10 sq.m area is going to cost us 40% more in rent. Rents have simply skyrocketed in the last 3 years. Additionally, we cannot simply move too far as we are bound by constraints of the daycare (already 7 km away). Thus the brilliant idea of buying an apartment was born, and we started to save for it.

You have to delay buying a home, because you do not have the money, isn’t it?

True again. Isn’t that always the case? I had been keeping an eye on a new development which was in a perfect location, and closer to the day care and yet not so far from the town center. An year of more purposeful saving made us come close to around 12% of the house value we had planned for (based on prices in the same area 18 months ago).

The price list came through on Monday, and it simply crashed through our plan. The prices of the apartments have risen higher than we had estimated, and our down-payment is lower than we wanted. I know I can probably get the apartment at 90% mortgage. I am tempted to try this, the apartment seemed perfect and had parks and no drive zone for children. But paying more than 35% of our monthly income for 30 years and extra maintenance money on top is not a financially wise decision. This is not how we Get FI! I do not want to write this purchase to be the title of my next Money Mistake post!

My wife and I had a long discussion this morning, and she just said,’We cannot take a 30 year mortgage which eats 40% of our income, this is stupid given that our child will be out of his daycare in 2.5 years‘.

She is right.

Delay buying a home. Hurts.

So, we have now reassessed our dreams and take a step back. We will save more next year, and are looking at places within our budget. Hopefully it might work out in 2020. I know I really liked that place, but I also like Maseratis

In the end, our homes are our safe spaces, and it is our loved ones which make them a home else they are just brick and cement.

Categories
Post

Is debt bad for Financial Independence?

Here’s a confession, I do like to watch Dave Ramsey on Youtube, his take no prisoners approach is quite entertaining. Yet, he often is condescending, which seems unnecessary at times. After-all, people are calling him for his support and reaching out is always a good positive step.

Debt is Bad, without explaining why

Dave Ramsey is also often considered as a strong proponent of debt bad movement. This is not bad advice at all, yet, is debt really bad for your goal of financial independence? However, instead of simply listening to the gospel, can we really assess this?

The purpose of taking loans

The first step is to understand, why is there a need to take debt? It is simply to finance a good or service which you otherwise cannot afford through your regular income and savings. You are borrowing against the promise of your future income.

Digging into my debt collection experience in finance industry

Around a decade ago, I was working in the finance industry in India. I had a few takeaways:

  • We had customers owning Ferraris on loan, with ridiculus payments, which they failed to pay off. In the eyes of their social circle, they were considered very rich.
  • Many customers financed their commercial vehicles to earn money by transporting goods, without learning the costs of the business.

Both of the above examples are the real issue here.

#1 : Debt is bad when you take too much of it

While banks might only look at your credit score or income statements, they cannot predict if you will be able to sustain your debt. Can your choice to buy a ferrari cripple rest of your finances?

If your debt repayment will make it impossible to save anymore each month, then you are buying more than you should. Pare down on your wants, and evaluate if you can opt for a more cost effective solution.

Great loan offers give us an illusion that our spending capacity is more than what it actually is. This often means, we are willing to consider buying things which we should ideally be out of our consideration.

#2 : Don’t call debt bad when your math is bad

The whole idea of debt as a financial product is to earn money through interest rates. This is the return the banks will get after you are done repaying your loans. Thus a simple comparison between two debt offers is comparing their interest rates (and reading the small print).

Comparison of interest rates may not be the whole picture, you should consider the total cost of ownership as well.

For example; if you are buying a car, you will end up having monthly car payments, fuel, parking, maintenance, winter tyres and insurance costs. Add it all up, and split into monthly payments. This number should be affordable, else you need a cheaper car or delay the purchase.

The same applies to buying houses, or rental properties and even buying a TV on loan (monthly payments + electricity + cable costs).

What is the downside of too much debt?

Lets stick to the math of taking debt, and avoid a discussion on mental stress. Let me share a real life example of a friend, he bought an apartment in India with a 25 year mortgage. His monthly payments translate to around 1000 EURs (converting from Indian rupees) at an interest rate of 10%.

As a single income household, he finds it really hard to save after his monthly expenses. His only means of saving are the mandatory rentenversicherung payments. His mistake was borrowing against future earnings of two adults instead of one.

In hindsight, a smaller cheaper apartment would have made sense.

What is an acceptable debt?

Acceptable debt is a combination of sufficient equity (downpayment), manageable interest rate and viable payments.

Household debt in Germany

In the current context of Germany, I would rank the below debts and my preference:

Type of DebtGetFI RatingWhy
Personal CreditAvoid Avoid due to high interest rates, unless you use it to pay off a loan of even higher rate.
Mortgage (Baufinanzierung)OkHistorically low interest rates (<2.5%), try to start with atleast 20% downpayment (more the better)
Credit CardAvoidUnless you can stick to paying off the whole credit each month, just avoid.
Currently interest rates range 13%-19% per year!
Payday loans (minikredit)RunIf you need to consider this, you are in trouble
Auto LoansOkI suggest a high downpayment, dont buy a car you cannot afford.
Make sure interest rates<4% and contract upto 48 months.

The debt principles

Lets summarize our tips for acceptable debt (I won’t call it good debt):

  • When financing a property, use a broker like https://www.loanlink.de/ to get best rates from banks specially when you are not comfortable with German. (I have not used their services, they are an example)
  • When buying a property, go 20% or higher in downpayment, else reconsider your decision.
  • Avoid new cars for loss of value, buy in cash.
  • If you still need a car loan then limit runtime to 4 years and interest<4%. Try not to finance more than 50% of the value of the car.
  • Do your math, for apartments add costs of commission, registration, maintenance. For cars, running costs, parking and maintenance. These will give you an idea of your monthly expenses.
  • Always check loan prepayments options before signing on. The goal should be to have the opportunity to prepay loans without a penalty fees.
  • In case of prepaying debts, hit the one with highest interest rate first.

In short, be responsible with your choices, do not take undue risk. Too much risk can make you poor.