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Debt Management for Healthy Borrowing

29 July 2019

Canada has a pretty interesting debt market. Despite having one of the highest household debt-to-income ratios in the world, delinquency rates remain low, and consumer confidence continues to prevail.
According to Trading Economics, the household debt-to-income ratio hit an all-time high of 176.28% in the last quarter of 2018, putting Canada in third place after the Netherlands and Switzerland. As of March 2019, the average household was spending 14.9% of its income on debt payments that include HELOCs, credit cards, and mortgages.
Historically cheap debt (meaning low interest rates), a notoriously resilient economy, and a healthy year-on-year GDP growth all contribute to Canadians’ confidence in the debt and lending landscape. However, this is no reason to be complacent; loans are an obligation that can prove to be either financially beneficial or detrimental, depending on how you utilize them.
Think of debt as an instrument to grow your wealth and improve your quality of life. To optimize the opportunities it can provide and overcome its pitfalls, savvy borrowers do their due diligence and manage their debt burdens in the most efficient way possible.

Debt prioritization and consolidation

Not all loans are created equal. When borrowing, be mindful of two loan characteristics: accessibility and interest rate. In general, the easier it is to take on the debt, the higher the interest rates are.
Credit cards, for example, are not very difficult to get; in fact, they sometimes arrive in the mail even when you never applied for them! They are one of the most common and easily obtainable types of loans, but the convenience also comes at a premium. Credit card interest rates average at 19%, with some going as high as 29.99%. Many people also fail to realize that credit card interest is compounded daily, meaning that after the grace period (usually 21 to 30 days), the remaining balance accrues interest on top of interest every day.
Like credit cards, HELOCs are a revolving line of credit. However, they use your home as collateral and have a much lower average interest rate of around 5.51%. A HELOC allows you to borrow back your home equity, capped off at 65% of the property’s total value. The ease by which one can tap into their HELOC and the fact that borrowers are allowed to pay down only the interest make this type of loan particularly tempting. However, there are caveats. One is that interest rates aren’t fixed, and banks can raise them at any time. Another is that banks can call the entire loan or a portion of it at their discretion. Perhaps most significantly, if property values drop, you could end up owing more than your house is worth.
Conversely, long-term debts, like mortgages, usually have lower interest rates and stricter terms that make borrowers less susceptible to misuse of the funds. This is not to say, however, that mortgages are risk-free. Letting debt management fall by the wayside could result in you losing your security (like your car, home, or other assets).
Responsible borrowing means knowing which type of loan best serves your requirements and how much debt burden you can carry based on your cash inflow. Credit cards, for example, are great for monthly expenses, but as a rule of thumb, it is prudent to keep your balance at zero. If a loan is too big to pay off in a month, don’t take it out of a high-interest credit card.
Most people carry more than one type of debt, and interest rates may vary. Ideally, a borrower should be able to pay all their obligations on time, but if one must prioritize, a good strategy is to tackle first the loans with the highest interest rates. Another is to consolidate the loans into one with a lower interest.

Hedging against interest rate hikes

Contrary to popular belief, even fixed-rate loans are not entirely a foolproof shield against interest rate appreciation. Not only do you pay a premium for these types of loans; rates can also be altered at renewal.
Lenders may also offer promotional introductory rates or even defer your amortizations. Common examples of these types of loans are “0% interest” credit cards and “buy now, pay later” promos. Premium rates may apply after a set period, so make sure to read the fine print when considering these types of debts.
It goes without saying that caution and preparation will prevent you from interest shock and paying more than your cash flow can handle, but another vital strategy that an overwhelming number of people fail to practice is paying off the principal. A survey published in January of 2019 showed that over a quarter of Canadians were making monthly payments only towards the interest of their HELOCs. Just paying this portion of a loan doesn’t lessen your debt burden, however, and increases in interest rates will only make it more difficult for you to meet your financial obligations. Settling an existing loan’s principal is still the most effective way to mitigate the effects of interest rate movements, which are out of your control.

Professional help

Pride has no place in debt management. Don’t hesitate to speak with a financial advisor and get advice on how best to make use of credit lines available to you. Not only will an outsider’s perspective give you more insight regarding your financial objectives, but it may also reveal your blind spots and where a loan may leave you vulnerable.
If you start consistently having trouble meeting your financial obligations, don’t wait for the interest to add up and your loans to balloon. Talking to your financial advisor or a credit counsellor may help you sleep better at night. There are both for-profit and not-for-profit credit counsellors who are experts at coming up with debt management strategies. They will audit your current situation to find out where your money is going, analyze the terms of your active loans, propose solutions, and even negotiate better terms with your lenders (especially if debt consolidation is the objective).

Debt utilization

Don’t stop at borrowing; use debt to jumpstart your wealth-growing activities and improve your cash flow. Income growth can enhance your lifestyle, sure, but it also breeds opportunities. For example, having more leverage puts you in a better position to negotiate with your lenders, whether or not you’re having any difficulty paying down the loan; a lender may agree to lower interest rates for the promise of increased, consistent payments generated by a business you started.
Debt doesn’t have to be a source of anxiety. In fact, having sources of funding made available to you is a privilege in itself—one that you can take advantage of to achieve your personal goals.

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