Kicking Debt Down the Road
By Robb Engen
December 3, 2019
Canadians started piling on the debt after the financial crisis in 2008. Back then our household debt-to-income ratio was sitting around 150 percent ($1.50 owed for every dollar of disposable income). Today that number hovers around 177 percent. We are kicking debt down the road, instead of kicking it to the curb.
It can be reasonable to take on debt for big ticket items such as a mortgage, vehicle, education, or for an investment. We often do so because it’s easier to pay off a loan over time than it is to save enough to pay the full cost upfront. That’s life.
But the pain of debt can be masked by the cheap cost of borrowing. Low monthly payments, interest-only payments, and long amortization periods give the illusion that our debts are manageable. We think a long overdue raise, promotion, tax refund, or some other windfall will solve our money problems, but until then the debts keep piling up.
We get trapped in an unending cycle of minimum monthly payments and creditors are happy to oblige if it means getting you into a bigger house with a new SUV and an annual trip to the Dominican.
Here are four ways we keep kicking debt down the road:
1. Minimum payments on your credit card
A cardinal sin of personal finance. We’ve all seen the disclaimers on our credit card statements that say if we only make the minimum payment each month it’ll take a lifetime to pay off your balance in full.
My latest American Express statement had an outstanding balance of $1,086 and the minimum monthly payment was only $10. At that rate it would take 9 years and 1 month to erase the $1,086 debt, and I would have paid another $1,000 in interest charges along the way.
Yet many people do this every single month. It’s easy to see why when you’re living paycheque-to-paycheque and there’s no wiggle room in your budget. A $10 payment gets the credit card company off your back and gives you some breathing room today. Unfortunately it’s your future self who’s forced to pay the bill.
The average credit card debt is hovering around $4,200, according to TransUnion. Most credit cards charge 19.99 percent interest or higher, making this one of the most expensive forms of debt to carry over from month to month.
That’s why I recommend treating credit card debt like a four alarm fire emergency. Slash your spending, pause any savings plans, and divert any extra cash you can towards your credit card balance until it’s gone for good. This is one debt you cannot afford to kick down the road.
2. Interest-only payments on your line of credit
The run-up in housing prices over the last decade has fueled a borrowing frenzy with Canadians tapping into their home equity at a record pace. Canadian home equity line of credit balances reached $230 billion earlier this year. That’s more than 3 million HELOC accounts open at an average outstanding balance of about $65,000.
One insidious feature of a HELOC is that it only requires a monthly interest payment. In fact, about 40 percent of HELOC borrowers don’t regularly pay down the principal.
Let’s say you have a $70,000 balance and the interest rate on your HELOC is 4 percent. Your monthly interest payment would be about $233 and each month that amount would be taken from your chequing account and applied to the HELOC balance.
But unlike other loan repayments there is nothing stopping a borrower from transferring that $233 right back to his or her chequing account – a move called “capitalizing the interest.” Also known as kicking debt down the road forever.
A big line of credit balance tends to linger until the mortgage comes up for renewal, in which case the borrower tries to roll the HELOC balance back into the mortgage, or until the homeowner sells the home and the balance is paid off from the sale proceeds.
A HELOC is not an ATM. It can be useful for a specific purpose, such as a home renovation or to buy a car. Using it to supplement your income, though, is a bad idea that will catch up with you eventually.
If you find yourself with a lingering line of credit balance make a plan to pay it off over a reasonable amount of time. Set up automatic transfers from your chequing account each month to match your target pay off date and start whittling down that balance today.
3. Extending your amortization
You bought a house and took out a mortgage amortized over 25 years. When it comes time to renew in five years, instead of sticking with your amortization schedule at 20 years, your mortgage broker talks you into extending the amortization back to 25 years to keep your payments low.
While it might sound good in theory to give yourself the flexibility of a low payment in case of emergency, it’s too tempting to use that option to free up extra cash flow for lifestyle inflation and spending.
Extending your amortization means never getting any closer to paying off your mortgage. It prioritizes today’s cash flow over tomorrow’s freedom – not something your future self will appreciate when you have to delay retirement until that damn mortgage is paid off.
The smart move is to not only stick to the original amortization schedule on your mortgage but also to reduce it further by changing your payments to bi-weekly instead of monthly, increasing your payment by $50 or $100 when your budget allows it, and taking advantage of your pre-payment privileges when possible.
Making mortgage payments is automation at its finest – forced savings that you won’t miss once it has left your account.
4. Long-term car loans
Canadian auto debt continues to grow as the average consumer’s auto-loan balance climbed to $20,160 last year. I’m on record saying that Canadians’ obsession with having two brand-new trucks or SUVs in the driveway is killing our finances.
Blame the fact that six and seven year car loans are now the norm.
The trend towards longer term car loans is problematic for two reasons. One, people are getting talked into buying more expensive cars at the dealership. That’s because the focus is about the monthly payment rather than the total cost of financing the vehicle. Longer term loans keep monthly payments affordable and increase the chances of selling an expensive vehicle.
Two, consumers get trapped in a negative equity cycle when they want to trade-in their vehicle before it’s paid off. The existing loan balance gets rolled into the new car loan, and the now more expensive car loan cycle begins.
Breaking the cycle takes sacrifice. Drive your cars longer (10 years+), buy used, only buy as much car as you need, reduce your household vehicles from two to one, and save up and pay cash for your next one.
Successful money management starts with being smart about debt. Kicking it down the road only prolongs the inevitable.
Tackle your credit card balance first, and be relentless. You’ll never get a better guaranteed return than paying down debt at 20 percent interest. Stop treating your home equity like an ATM and start paying down the principal. Don’t wait until you sell your home.
Stick to your amortization schedule and try to pay off your mortgage in 15-25 years. Extending your amortization or taking payment vacations is not a path to prosperity.
Finally, break that auto-loan cycle. Long term financing might make your monthly payments more affordable today, but it’s awfully expensive in the end, especially if you keep trading in your car every 3-5 years.