In the news, there seems to be an ever more frequent reference to the increasing level of personal debt carried by Canadians and the perils of rising interest rates that may leave many in financial difficulty. The reality is debt is not all bad. Most of us wouldn’t have been able to purchase our home, or buy a car, or pursue post secondary education without borrowing. Even credit cards are not evil in and of themselves no matter how they are often portrayed.
To never borrow money is to live in the land of the already rich or always be a renter. At the other extreme, using other people’s money to fully finance your lifestyle is ridiculous and precarious. Most of us don’t fall into these extremes. We hold a reasonable amount of debt, make our payments on time and have a good credit rating. That being said, most people fail to optimize their overall debt management strategies to pay the least amount of interest.
Consolidating debts
We no longer hear a lot about the “all-in-one” mortgages offered by financial institutions. These accounts combine chequing, savings, and borrowing into one account. If used properly, consumers could simplify their debt and lower their overall interest paid. These won’t work for most people because they like to keep all their accounts separate. They have multiple liabilities at different interest rates:
- Home mortgage
- Car loan
- Line of credit
- Student loan
- Credit cards
Banks give out consolidation loans to clients who have trouble managing debt. They will confiscate and cut up credit cards, cancel overdraft protection, and close out other loans and lines of credit. Voila, your consumer debt is simplified. In the end, within a couple of months, more than half of these clients re-apply for their credit cards, reinstate ODP, and sneak off to a different branch to get another line of credit. The symptoms were treated but the debt diagnosis remains.
Personal debt mismanagement
In discussing personal debt and to highlight people’s perspective on debt management, I thought it useful to share some real client examples that we encountered. These reflect people who were not thinking clearly about managing their personal debt before we engaged with them.
Chris and Karen
Chris and Karen were determined to pay off their mortgage (3%) in less than 10 years. They put every available dollar towards the principal. They had two car loans at 5% and 8% and purchased a “don’t-pay-for-six-months” entertainment system. It made more sense to address these debts first before making additional principal payments on the mortgage.
Don and Donna
When their mortgage came up for renewal, Don and Donna rolled the balance into a new Home Equity Line of Credit (HELOC). However, they continue to finance their lavish life style with their credit cards. They pay off the cards each month from the HELOC on which they make the required minimum payment of accrued interest. After all, they have a huge balance still available to them. They think they are managing their debt well by paying off “bad” credit card debt and having “good” mortgage debt.
Cindy
Cindy went to her favourite home decor store to purchase sheets. There was a store promotion that gave 20% off purchases when opening a new store credit card. Excited by the discount, Cindy picked out a whole bedding set. The balance is too high to pay when the bill arrives so she makes minimum monthly payments while incurring interest charges of 29%. Meanwhile, she has enough money in her low-interest savings account to pay the entire bill, but chooses not to.
Peter
Peter works on commission and his pay cheque amounts vary. He makes up the difference in lean months with his bank overdraft protection at 24%. Until he learns how to budget for his irregular income, he should use his credit card for purchases, even if he carries a balance for a month or two.
Rick
Rick received a credit card offer with 0% interest on balance transfers. He transferred the balance from his high interest rate card and cancelled it. He uses his new card for future purchases, not realizing that the 0% only applies to the amount transferred. His payments go to the new purchases he made which carry a higher rate. He would have been better off to continue using his old card for his new purchases, pay the monthly balance in full, and avoid using the new card.
Brandon and Becky
Brandon and Becky have a systematic plan to pay off all their debt. They are using the “snowball” method which states that it is psychologically satisfying to first rid yourself of the smallest debts first, regardless of interest rates. The reasoning is they would be better prepared (and more enthusiastic) to stick with the strategy. But, once the small debts were done, they took their foot off the gas and paid random amounts on the higher debts whenever the inclination hit them.
A Perspective
While this provided a perspective on the management of personal debt, emotions and wants always get in the way. In truth, the logical use of interest rates should prevail. Instead of speculating about the direction of future interest rates, we should be examining our own habits.
Take a look at how you think about, and manage, your personal debt and see if you can minimize your borrowing costs. It’s a good exercise and one that can be assisted when working with a non-biased financial planner. After all, we need to put life in perspective in our Financial Life Plan. It’s one way of Keeping Life Current.
