This month on social media we have been focusing on Consumer Debt, ways to reduce and eliminate debt and what types of debt is preferable to others. Typically, January is a month of resolutions... eating better, losing weight, exercising and getting control of our finances. It's also when those pesky credit card bills arrive from the holidays which can cause people to go into panic mode. So, let's talk about some strategies on how to get a handle on our debt!
Paying off Debt
Preferably, the best course of action would be to pay off our Consumer Debt (not secured by a mortgage), and there are two popular methods to accomplish this, the Snowball and the Avalanche method. The Snowball method focuses on paying off the smallest debt first, whereas the Avalanche method targets the debt with the highest interest rate. While the Avalanche method does pay everything off a bit sooner, depending on the balances, it can take a while to get that first debt paid off and this can feel discouraging and may cause you to lose faith in the process. The Snowball method pays off the first debt quicker (as it focuses on the smallest debt) so can be more motivating to keep you on track and going strong with the plan!
Let's look at an example:
Jane Foster owes a total of $20,000 in consumer debt, she has budgeted $750.00 a month to put towards paying down her debt which consists of
- a $7,000 car loan, at 4% interest with monthly payments of $250.00
- a $4,000 line of credit at 6% interest with monthly payments of the outstanding interest owing
- a credit card with a $9,000 balance at 20%
Using the snowball method, we are going to pay off the smallest debt first which is the Line of Credit at $4,000. Jane will pay her monthly obligation of $250.00 on the car loan and the minimum of 3% of the balance on the credit card balance. The remainder of her $750.00 will go towards the Line of Credit.
Using this method, Jane will have her line of credit paid off in 17 months and will then take her extra funds and put them towards the car loan. With the extra funds now going towards the car loan, this will be paid off in month 23. We then do the same thing with the credit card which will be paid in full by month 33.
If we follow this process but using the Avalanche method (highest interest debt first), Jane will pay off her credit card in month 23, the Line of Credit card in month 31 and the car loan paid off naturally in month 30.
You can see how the Avalanche method paid off all of our client's debt two months sooner than the Snowball method but the motivation of having the first debt paid in full six months earlier may make the process easier to stick with.
Debt Consolidation
What do you do if your debts are too high or you're struggling just making the monthly commitments and there isn't room in the budget to add a bit more? This is where considering a consolidation loan may make sense.
This type of loan looks at paying off all of your debts and combining them into one payment. In our example above, if Jane had done a consolidation loan for the full $20,000, assuming an interest rate of 8% over 4 years, she would have one new monthly payment of $488.26.
Some things to keep in mind: If you don't have some net worth built up (RRSPs, equity in your home, etc.), it may be difficult to find a Bank or Lender willing to loan you a large sum of money to consolidate your debts. If you don't have security to offer (either under a mortgage or a vehicle), the interest rate can be very high and you may be forced to look at non-bank options such as stand-alone loan companies.
Good Debt vs. Bad Debt
Is there such a thing as "Good Debt"? Well, many think debt can be a useful tool to build wealth if used properly. What you want to consider is what are you getting into debt for? If the purpose of the loan or mortgage is to pay down / off consumer debt, then you are not increasing your overall wealth or net worth and this may be considered a "bad" form of debt.
If, however, you are borrowing money to make an investment such as an RRSP, real estate or something that will increase in value (and no, cars do not count!), then this could be considered "good" debt since it is helping you to build your wealth. This also applies if you are borrowing to improve an existing asset, updating or renovating your home or other asset, which will increase it's value.
A word of warning when borrowing funds to invest. This type of borrowing is often referred to as "leveraging"... Using the value of one asset to purchase another. Depending on what you are investing the borrowed funds in, no matter what happens to the value of the investment purchased, you still have to pay back the loan you took out to buy it. Several years ago, this type of borrowing was all the rage with investment advisors, where they encouraged homeowners to borrow against the equity in their homes to build up their stock or mutual fund portfolios. This was very risky because of the potential volatility in the stock market and many people ended up significantly in debt with little to show for it when the market went through a correction or down-turn.
Hopefully, the above strategies have given you some strategies when it comes to building wealth and reducing debt. If you find yourself in a situation where you need help, reach out to your financial advisor and see if any of these options make sense for your particular circumstances.
Brenda St Amand is an independently licensed Mortgage Agent in Barrie, ON with many years of financial and credit experience. Working with her clients to create individual strategies to meet their home ownership and wealth goals is what a good day's work is all about!