PWL Capital July 28, 2015 Personal Wealth Starting Out Fundamentals of Debt Why do People Borrow? People borrow to bring forward expenditure. Conversely, people save to defer expenditure. Bringing forward expenditure comes at a cost, interest, while saving is rewarded by investment returns. How much debt costs depends on the risk that the borrower may default (i.e. not pay the loan back), which is called credit risk, and the borrowing period (also known as term risk). A borrower who can borrow against assets they own (e.g. a house), will be able to borrow at a cheaper rate, than if the loan was not secured by assets. Debt can be both a good thing and a bad thing. Broadly, speaking, debt may be considered good if it enables you to increase your future income. A good example of this is taking on student debt to earn a degree that will result in a higher income in the future. Many people also view purchasing a house as good debt. The assumption is that the rise in value of the house, less the cost of ownership (including mortgage interest payments) will compare favourably with renting the same property. Whether it’s a post-secondary education, a house purchase, or something else, there is still risk (you may lose your job, house prices may fall, etc.). Bad debt typically involves immediate gratification but no increase in future income. Examples could include an expensive holiday, luxury cars, etc. Types of Debt There are many types of consumer debt available. Outlined below are a few of the most common for young professionals: Credit Cards: as long as credit cards aren’t abused (buying things you can’t afford, maxing the limit and not paying it off monthly), credit cards can offer some great advantages over paying with cash. Some of these include travel insurance, purchase insurance, rewards or points, depending on the specific card. Unfortunately, if you don’t pay off the balance each month before the due date, they charge extremely high rates, upwards of 20% on the total balance outstanding plus any new borrowings. Personal Lines of Credit (LOC): Lines of Credit are loans from banks that are typically revolving (i.e. any amounts paid off can be borrowed again). Some lines of credit are secured by assets, while others are simply backed by the borrower’s earning capacity. Secured LOC’s offer the benefit of preferential rates over unsecured LOC’s. For example, if one uses a LOC to pay for a car purchase, the bank has the option to repossess the car (if you don’t make your payments), sell it, and pay off the loan. Since it’s less risky than an unsecured LOC, you can get a lower rate. Student Loans: this is a very common type of debt for young professionals. The most popular in Ontario is OSAP, followed by loans from banks. I will go into more detail on these in a separate post. Mortgages: These are a type of secured loan to help pay for a house. You own the home, and use it as an asset to secure the loan (providing the opportunity for lower interest rates). The standard mortgage is offered by banks, independent mortgage brokers, etc. There are many specifics when it comes to mortgages, which I won’t go into detail here. Reducing Debt There are a few basic guidelines for paying off debt: If you are tight on cash each month, pay off at least the minimum you owe for each debt. This will ensure you don’t default on any of the loans, which will negatively affect your credit rating. Pay down debts with the highest interest rate first. For example, say you have a balance of $2,000 on your credit card, running at 18% interest and $10,000 in a Line of Credit with a 5% interest rate. If you have $3,000 to use to pay off debts, you should eliminate the credit card first, then the Line of Credit. CREDIT CARD PAID FIRST LINE OF CREDIT PAID FIRST Balance Interest Balance Interest Credit Card $0 $0 $2,000 $360 Line of Credit $9,000 $450 $7,000 $350 Total $450 $710 If you have multiple loans, it might be beneficial to consolidate those loans into one with better terms (i.e. lower interest rates). Many banks offer debt consolidation options, including Lines of Credit. Say the above example was a real estate agent who knew they were receiving a big paycheck 2 months from now, but didn’t have any cash available to pay off the credit card balance. If the limit on the Line of Credit was $15,000, they could pay off their credit card by borrowing from the LOC and increasing the balance to $12,000. Two months from now, they could pay off some or all of the Line of Credit with their paycheck, and they would pay 5% interest on the $2,000 Credit Card balance rather than 18%. Finally, the best way to eliminate debt is to pay down as much as possible as early as possible. A simple guideline I’ve explained in my post Saving and Budgeting, is to put 20% of your after-tax income towards saving and reducing debt. If you can trim your budget to get to that 20% or more, that will help rid your debt more quickly and save on interest. How does Debt affect your Credit Rating? Having a large amount of debt doesn’t necessarily mean you have a low credit rating. While your level of debt may affect how much you can borrow right now, your credit record/rating is a history of how well you repay debt. If you show that you pay back your debts on time and consistently, even if the balance is large, your credit rating should not be adversely affected. If you don’t currently have debt and have not had any debt in the past, credit cards can be a good way to build up some credit history, as long as you are paying them off in full each month. Other helpful items Debts are often quoted as “Prime + X%”. Prime, or the prime business rate, is set by Canadian financial institutions. It was just lowered to 2.7% (from 2.85%), as a result of the Bank of Canada’s decrease in the Target Overnight Rate. Most banks list what the prime rate is currently on their websites, or you can find it under “Interest Rates” on the Bank of Canada Website. Rates are shown as annual figures (unless stated). Almost everything is negotiable, and there are many options when it comes to borrowing. For mortgages, for example, get quotes from at least 2-3 sources, including independent mortgage brokers as well as your bank. If you cannot afford your debt payments, the worst thing to do is simply not pay them. If you are struggling, contact the lender and ask for help. They would much rather reduce your payments to make them more manageable, than have you not pay them at all. If this sounds intimidating, consider talking to a not-for-profit credit counselling service in your area. With respect to your credit rating, it is a good idea to review your credit report to make sure there are no errors. Equifax and TransUnion provide you with your credit report (not your rating) for free once per year. For an explanation of the difference between credit reports and credit scores, read Credit score vs. credit report: What’s what? It’s not a bad thing to have debt, as long as you don’t abuse it and have a clear plan for paying it off. Share: Facebook Twitter LinkedIn Email