INDEPTH: PERSONAL FINANCE
Dealing with debt
by Tom McFeat, CBC News Online | September 14, 2006
Borrowing money is not by definition a bad thing. Borrowed money
can allow you to get something you need (like a house) years
before you'd be able to buy it outright with saved cash. But
when borrowing becomes a habit, when you never seem to pay down
your debts, when the amount you owe threatens your financial
well-being, then you need to deal with the problem before it
gets any worse.
Spend less than you earn
Spending less than you earn seems so obvious. But it's by far
the most important advice financial planners give their clients.
| Quick Fact: |
Canadian households carried about $1.08 in debt for every dollar of disposable income in 2006.
Source: Statistics Canada
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But sometimes when you buy on credit and carry a balance from
month-to-month, it's not easy to figure out exactly how much
you're spending. There's only one way to be sure. Keep a log
of every cent you spend. It sounds tedious. But it will reveal
everything you'll need to know about where your money goes.
At the end of every day, just write down what you bought or
spent that day. Using a spreadsheet program will make it even
easier. But a pen and notebook will do as well. Do this every
day for a month.
Be sure to include the big monthly expenses like mortgage, rent
and car payments. And don't forget bills that may just come
once a year (like holiday presents, vacations, car insurance,
RRSP contributions). Just divide by 12 and add them to your
monthly total.
The result may surprise you. If you are, in fact, spending less
than you take home each month…congratulations. If you're spending
more, you have three choices: 1) spend less; 2) earn more; or
3) spend less AND earn more.
For most people, it's much easier to spend less than to earn
more. You can certainly save by taking your lunch to work instead
of eating out, cutting out that morning latte and muffin, and
taking public transit. Another way to spend less (and this one
is painless) is to structure your debt so that you pay less
interest.
Restructure your debt
A recent Ipsos-Reid survey for Scotiabank found that almost
half of the people they contacted (46 per cent) were paying
more interest than they needed to. Canadians were paying billions
more than necessary to service their mortgage and credit card
debts simply because they didn't know how to find the cheapest
rate, or didn't know how to convert high interest rate debt
into lower interest rate debt.
Shopping around for the cheapest credit is the most obvious
way to save on interest costs. In the section on credit cards,
we showed you how to find the cheapest cards. A mortgage broker
can find you mortgage money that will almost always be cheaper
than the posted rate at most banks. Some virtual financial institutions
also offer mortgages at rates below those of the major banks.
But with competition intense these days, even the big banks
are willing to dicker on everything from mortgages to new car
loans.
And speaking of new car loans, dealer financing is usually better
than what any other lender can offer. Zero-per-cent financing
simply can't be beat!
Refinancing your mortgage
Quick Fact:
|
Pay off your mortgage faster
A $200,000 mortgage at 5.5 per cent carries a monthly
payment of $1,220 when amortized over 25 years.
The same mortgage amortized over 20 years boosts the monthly
payment by just $148 and saves almost $38,000 in interest
costs.
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Refinancing a mortgage is one of the easiest and most beneficial
ways of lowering monthly payments. A study by CIBC World Markets
economists in the spring of 2004 found that Canadians saved
$7 billion in the previous two years by refinancing their mortgages
to take advantage of low rates. That works out to an average
of $4,000 per household.
One in three mortgage holders who refinanced in 2002-2003 also
used the equity in their homes to increase their mortgage principal.
While on the surface, this seems to run counter to a "pay down
debt" strategy, it makes sense when the extra money is used
to pay down expensive credit card debt.
The minimum payment on a $10,000 credit card debt is usually
$300 a month (and remember that interest will continue to build
on the principal at 18.5 per cent a year). An extra $10,000
on a 5.5 per cent mortgage amortized over 25 years costs $61
a month. So by just switching the debt from the credit card
to the mortgage, your monthly cash flow is $239 healthier. For
those with monthly cash flow problems, that can be a life-saver.
Personal lines of credit
A line of credit is one of the cheapest sources of money you'll
ever find. Your financial institution pre-approves you for a
maximum amount of money it will let you borrow. The line of
credit can be secured against your home or other asset, or it
can be unsecured. Secured home equity lines of credit can be
as low as prime. And while these rates rise and fall along with
the prime, they'll usually be much lower than what you'll be
paying for department store or credit card debt.
Smart borrowers use this money to pay down those expensive credit
cards. Even smarter borrowers make sure that once they've consolidated
their debts, they don't march right out and refill their now
debt-free credit cards with new charges.
Consolidation loans
Unlike a line of credit, where the money can be spent on anything,
a consolidation loan is taken out for the express purpose of
paying off higher-interest-rate debts. The financial institution
may want to make those payments directly to your creditors so
it knows the money has gone there, and not for a holiday in
Las Vegas. You will then make monthly payments to the bank or
financial institution instead of the credit card issuer. You'll
pay less interest than the typical credit card charges. The
bank may also ask you to cut up your credit cards. If it doesn't,
you should do that anyway. It's too easy to slip back into the
"just charge it" mentality.
For those who are beyond the help of debt restructuring, mortgage
refinancing or consolidation loans, it's time for more drastic
action. That doesn't necessarily mean filing for bankruptcy.
More about that in the section outlining options for those in serious debt trouble.
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