It’s everyone’s least favourite word—debt. Usually, debt accompanies another four-letter word, but we’ll let you fill in the blank there.
We have talked about debt before but 2020/2021 changed the personal debt game for a lot of people, both for better and worse.
According to Statistics Canada, total non-mortgage debt (i.e. unsecured debt) fell by a record $20.6 billion from the beginning of the COVID pandemic to January 2021. The majority of this decline was from credit card debt. With limited spending options and people benefiting from support from the Government and Employers to offset lost wages, it was a good time to pay down debt.
But (again, there’s always a but), that was early 2021. With turbulent reopenings and slow economic recovery, our debt problems are making a comeback. On average, Canadian’s carry $1.73 in debt for every dollar they made in the last half of 2021.
All trends aside, debt is as we said in the title, personal. But how do you know when you have too much debt? And, more importantly, how can you make a plan to reduce it?
How Much Personal Debt is Too Much?
When we look at a client’s file, we look at two things; how much are you making and how much debt are you carrying?
We can quickly tell how much of your gross monthly income goes to paying down your total debt load, including housing payments, with the Debt-to-Income ratio.
From a lending perspective, if 44% or more of your gross income goes to paying debt, you’re probably carrying too much debt. Remember, this is just using your gross income and making minimum payments on your debts, but it gives us a good understanding of where your money is going.
So, if you’re at or over this 44% ratio, let’s take a look at how you can reduce this percentage, and get your debt to a manageable amount.
Note: Before we go on, we have to say that carrying debt isn’t a bad thing. After all, you need to have a credit history, which means carrying some debt, to buy a house! We want to help get you into a place where less of your money is going towards paying debt.
Tip #1 For Tackling Debt: Start with the Highest Interest Rates
As your debt amount increases, a significant portion of your payments will go towards paying the interest and not towards the principal. At this stage, you’re not making any progress on reducing your debt load.
When determining which debt to conquer first, start with the one that has the highest interest rate. Many credit cards carry a 19.99% interest rate or higher. We have seen some at 29%! You’re going to pay more one those debts over other unsecured loans or home equity lines of credit which can carry single-digit interest rates.
Step 1: List all your debts with the highest interest rate item first
Step 2: Set up minimum payments on all other debt items (you still need to pay these!)
Step 3: Pay more than the minimum payment on the highest interest rate item until it is paid off.*
Step 4: Once that debt is tackled, start on the next item. Use the money you would have spent on the previous debt item, to pay the second.
* Remember, this amount has to include the amount you spent that month on the credit vehicle. If you spent $200 on your credit card, you would have to pay $200 in addition to your increased payment.
Tip #2 For Tackling Debt: Refinance Your Mortgage
This is for our folks who own a home, so if you’re not a homeowner yet, skip down to the next tip.**
Refinancing your mortgage could be a great way to use the equity in your home to tackle some debt. With a refinance, you may be able to restructure your current mortgage agreement to lower your payments or borrowing costs.
Refinancing your mortgage allows you to access the equity in your home so you can use the extra cash for a variety of reasons, including consolidating and paying off your high-interest debts.
Now, there are some instances where we don’t recommend doing a refinance. When you refinance, you are breaking a contract so will have to pay the lender a percentage of the mortgage principal. If it costs more to break your mortgage than the current debt you carry, this isn’t the right move.
Tip #3 For Tackling Debt: Reduce Contributions to Savings
Ok, before everyone comes at us for this tip, answer this question:
What’s growing faster? The interest payment on your credit card or the savings in your RRSP, TFSA, etc.
When you’re facing a high debt load, it makes sense to temporarily reduce or stop contributions to your savings accounts to increase the amount you put towards debt. The more you can contribute towards the principal of your debt, the faster you can get rid of it.
Once you’re feeling confident about where you are with your debt, you can go back to contributing to your savings.
Tip #4 For Tackling Debt: Debt Consolidation Loans
A debt consolidation loan is a lump sum loan that is used to pay off or reduce outstanding debts, such as credit cards. Once these debts are paid, you only have to one monthly payment on the consolidation loan at a lower interest rate.
However, these types of loans do have a few requirements:
You have a history of consistent and stable income,
Your current debt payments are in the range of 40 percent or less of your income,
You have a good credit score,
You may need collateral to secure the loan.
You can find some banks or financial institutions that will lend without collateral, but these typically have higher interest rates, making them a more expensive option. Again, you want to be directing more money to the principal, not the interest payment.
Tip #5: The Most Boring Debt Tip of All—Budgeting
Managing debt comes down to simple budgeting; are you able to pay off all or most of the balance each month or are you only able to pay the minimum payments?
If you can only do the minimum payment, what’s preventing you from paying more? Often, it requires a shuffle in spending priorities (not always sacrifices) to tackle debt.
We have seen our clients do some incredible things with tackling their debt when they put money in the right spots—heck, some of them were able to reduce their debt to buy a house all within the same year! So, what do you need to prioritize in your budget to get you on the road to debt-free living?
* * P.S. If you’re looking to become a homeowner, we got you.