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Enriched Academy Staff
You don’t have to look at the news for very long before you see a headline about the debt problems of the average Canadian – and the numbers can be quite shocking!
• Average consumer (non-mortgage) debt: $21,000
• Average household debt to disposable income: $1.82
• Most indebted age group: 46 to 55 years ($36,241 non-mortgage)
• Average credit card debt: $5679
The only positive has been that over the past couple of years, carrying debt (credit cards aside) in Canada has been pretty cheap. Anyone with access to home equity could have easily cashed in on rising house valuations and gone on a major spending spree at a pretty manageable cost somewhere between 2% and 3%.
Unfortunately, the consensus now is that those rates were once-in-a-lifetime bargains and aren’t likely to be repeated anytime soon. Interest rates have already risen sharply in 2022 and we are not through yet. The Bank of Canada overnight rate which is used as the benchmark for most loan agreements has risen from 0.25 % at the start of 2022 to 3.75% in October and is likely to rise again in December.
Despite the daily headlines about rates rising at a record clip, many people remain in the dark about just how much they are paying (or will soon be paying) to service their debts. Part of the reason for our nonchalance might be that we have all forgotten how interest (both simple and compound) can add up!
Car loans are a good example. The days of ultra-cheap financing have all but disappeared and according to Stats Canada the average car loan is now at 6.62%. While a lot of us can borrow at a lower rate depending on our credit score and the dealership, a 7-year loan on a $35,000 car at 5% is going to cost you $6554 in interest charges. Shortening the term to 5 years (what used to be the norm for car loans!) will reduce that down to $4630 and save you almost $2000 in interest charges.
Before you convince yourself a shiny new ride is well within reach by simply adding a couple of years to the financing term, make sure to calculate and then rationalize the added interest cost, not just whether the bi-weekly payment is do-able. Don’t forget to factor in depreciation (currently very low thanks to the shortage of cars) as well as the total operating costs including gas, insurance, parking, tires, oil changes, car washes, etc. — which are getting more expensive by the day!
If you do the math on your house, the pain is much worse, and you need to start budgeting for when your current mortgage agreement expires. If you are renewing a fixed rate mortgage from 5 years ago, you are likely looking at somewhere around 2% more. On a 25-year, $400,000 mortgage, moving from 4% to 6% will cost you about $500/month more. If you have a variable rate mortgage, you have probably seen it increase by the full 3.75% increase this year and that works out to a bump of almost $900! If you have a variable rate mortgage with a fixed payment, you are in for a huge increase and you may have to adjust your amortization schedule when you renew as your current payment may barely be covering the interest.
Home equity backed lines of credit are another area where borrowing costs have increased dramatically and will very likely continue to rise. A quick Google search shows these rates are now hovering in the mid 5% range, about double what they were 2 years ago. We agree that not all debt is bad, and home equity is often a great option to draw funds and pay down higher interest debts. However, it is no longer a source of super cheap cash for vacations, home renos, cars, furniture, etc.
If you are eyeing home equity to fund a $100,000 kitchen and bath renovation for example, make sure the accompanying $5500 in annual interest expense (assuming you pay interest only) is within your means. Also ensure you fully understand the terms and conditions for repayment and have a solid plan in place for paying it back and/or refinancing. Don’t forget that interest rates are most likely going higher and home prices may continue to fall — a double whammy that would easily slam the value of that $100K kitchen investment and put it way underwater very quickly!
The perils of credit card debt are well documented, but it bears repeating as the average Canadian owes their card company around $6000. Not all credit cards have high rates, but most are pushing 20% and even “low-rate credit cards” are seldom below 10%. The good news is that credit card rates don’t usually move with other interest rates and are bound by your cardholder agreement, so you may not see much change. The bad news is that credit cards are quite unique in that the interest charges are compounded daily, and the minimum monthly payments are shockingly low.
Paying the 3% minimum on a $1000 balance at the usual rate of around 20% will take around 11 years to pay off and cost you another $1000 in interest charges. Even the so-called “low-rate” card at 10% interest will require almost 8 years before you eliminate the balance. Paying the minimum balance on a credit card is an almost a never-ending debt cycle. Adding even a small amount ($50) to the minimum can make a big difference — learn just how much here.
Student loans are another type of debt that could see a dramatic increase when the interest-free period imposed during the pandemic on Canada Student Loans (federal) comes to an end in March 2023. If you elected to pay back your student loan at a fixed rate (prime +2%) you were likely paying around 4.5% in April of 2021. Based on current interest rates (which are expected to go higher] the interest rate on your Canada Student Loan will rise to almost 8% when the interest resumes in April of 2023. There has been some talk of loan forgiveness programs, but the current Repayment Assistance Plan is quite limited, and nothing has been announced so far on any other assistance programs.
A lot of people struggle with debt because they don’t really understand the details. Do yourself a favour and take the time to learn why paying the minimum on your credit card balance is futile and costing you a fortune, or how those fixed payments on your variable rate mortgage are fast becoming a huge liability as interest rates rise.
Not all debt is bad and it is a fact of life if you are eyeing a new car or buying a home. However, that’s no excuse to sign on the dotted line without fully understanding your obligation to repay that money an under what terms and conditions. There is no way to reliably forecast which way interest rates may go but they were historically low through the first quarter of 2022, and it isn’t likely they will be returning to those levels anytime soon — understanding the details of your debt will help you cope with future changes and find solutions.
There are lots of reasons people fall into debt but only one way out — and it’s going to require a combination of planning, discipline, and persistence. Here are the basic steps for effective debt management to help you get started.
Start by gathering information about all of your debts — student loans, credit cards, lines of credit, car loans, overdue bills — everything. Make a list of all the debts with the details of the amounts owed, interest rate, and minimum monthly payments. This will help you set goals, create a timeline, and prioritize your repayments.
Creating a Debt Management Plan
Your first goal is to make sure everyone gets paid the minimum amount required to avoid your debts going into arrears. Overdue bills and missed payments are going to play havoc on your credit score and it can take a lot of time and effort to rebuild. Although paying the minimum on a credit card balance will keep your credit score intact, it won’t get you out of debt. A $1000 balance will take well over 10 years to payback and incur another $1000 in interest if you only pay the minimum 3% payment.
The next step is to figure out how much more you can allocate from your current income for debt repayment. At this point, a lot of people will quickly deduce that more income is the solution, and immediately go out and get a second job to make extra money to pay off the debt. While more money will definitely help you reduce debt and is one option, it isn’t the first step. In fact, for most people, the more you make, the more you spend! Working more will also cause a number of other issues — less free time or time with friends and family, more stress, higher income taxes and possibly reduced government benefits like CCB.
The most important step is to create a realistic budget. Reducing the expense side of your monthly budget is going to free money to pay off debt much faster than pumping up your income on the top line. You need to identify areas where you can reduce expenses and channel those savings to your debt repayment fund. It’s critical to start accurately tracking your expenses and get the actual data on your spending, not just a guesstimate based on your feeling.
You also have to use a zero-based approach. What you currently spend shouldn’t be a basis for future budgeting. Just because you spent $500/ month at bars and restaurants doesn’t mean that cutting back to $250 is going to solve your debt problem. If you spent only $100/monthly at the pub and channeled another $150 to your credit card payment, your interest savings would pile up quickly and you would eliminate the balance many months, if not years faster.
Whether you use the latest budgeting app, a Google spreadsheet, or a pen and paper to analyze and track expenses doesn’t matter. You can eliminate what you can’t see, and expenses are no exception. Even if you think you have a pretty good handle on your spending, go through the exercise and you may be surprised.
Debt reduction strategies
Once you go through your expenses and identify a realistic number you need to get by, it’s time to commit and lock away your debt repayment amount from each paycheque. One way to stay on track is to set up another account and just have a portion of your paycheque deposited straight into it, then you can just go in that account and dole out the funds according to your repayment plan.
When it comes to who to pay first, there are two commonly used strategies for prioritizing debts: the debt avalanche method and the debt snowball method. With the avalanche method, you focus on paying off the debt with the highest interest rate first while making minimum payments on other debts. The snowball method involves paying off the smallest debts first, regardless of interest rates, and then moving on to larger debts.
From a financial perspective, the avalanche method is the best way to pay off debt, especially if the interest rate differential is large. It makes no sense to pay off a small amount on a home equity loan at 6% if you have credit card debt at 20%. However, if you are paying credit card bills with similar interest rates then the snowball method could give you motivation and momentum. However, if you write a clear debt management plan and use that to track your progress towards goals and gain motivation, then the snowball method has little to offer.
While you're working to pay off debt, it's critical to avoid adding further debt to the pile. If your willpower is waning, put a temporary hold on your credit cards and focus on making cash or debit card purchases within your budget. It isn’t a problem to continue using your credit card as cash is pretty inconvenient for some transactions, just make sure you go into your online banking and pay any new credit card charges right away.
Tricks to paying off credit cards
For most if us, there isn’t anything more expensive than credit card debt and this is where you should focus. Most cards charge around 20% and even the so-called “low interest” cards are usually around 10%. This is still higher than most car loans, student loans or lines of credit. The other problem with credit cards is the ridiculously low minimum payment. The fact is that making the minimum payment is almost futile and will keep you indebted for many years. You need to make the minimum payment plus and additional amount, and it is surprising how much of a difference that small additional amount can make. This calculator is a great tool for analyzing credit card repayment options and you can easily see for yourself how paying the minimum plus $50 on a $1000 balance will cut the repayment period from 131 months to just 18 months.
If you have been making payments and your credit rating is not too bad, you may be eligible for a credit card balance transfer offer with a promotional 0% interest rate for a specific period. This allows you to consolidate your balance on one card and pay off credit card debt credit without accumulating additional interest. The key issue is to make sure you can completely eliminate the debt before the 0% period expires, otherwise you will face penalties and other charges that are likely to put you in an even worse situation than before! Makes sure you have a realistic plan and are disciplined before you sign up for any balance transfer options or credit card consolidation loans. They are one of the best ways to manage credit card debt as they defer the interest, but you need to stay very disciplined.
If you're struggling to meet your debt obligations, consider contacting your creditors to discuss potential options. They may be willing to negotiate lower interest rates, a reduced payment plan, or even a settlement amount. Exploring these options can help you make your debt more manageable. Even a slight reduction in interest can save you money over time and accelerate your debt repayment. Alternatively, you can explore debt consolidation loans from reputable financial institutions or some form of debt counseling.
While it may seem counterintuitive to be paying off debt and saving money, having an emergency fund will help you to stay on target. Make sure to set aside a small amount each month until you have enough to cover unexpected expenses. This prevents you from relying on credit cards or loans when emergencies arise, helping you avoid accumulating more debt.
Paying off debt is a long-term commitment that requires discipline — there is no quick way out. Being aware of the true cost of your debt and visually tracking your progress are great motivators. Try making a spreadsheet or some form of debt payoff chart to keep you committed. Once you get started and see some progress, your mindset will begin to shift, and a huge weight will start to lift. Becoming debt-free or at least in a position where debt stress doesn’t consume your life will do as much for your mental health as it will for your financial health.
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