Financial Fundamentals (Pt 3) - ‘Bad’ debt and when it gets out of control.

We’ve talked about budgeting and cash flow, and next on our list of financial to-do’s is focusing on debt repayment. I like to think of debt in two categories - good debt and bad debt.

So what is good debt? Any debt that will work to increase your wealth over the long term can be good debt. Mortgages are the prime example of this, and in fact most people that have a mortgage don’t even consider it when discussing their debt (although if you tried to sell the bank on this idea I think they would beg to differ). Since homes are an asset class that are generally assumed to increase in value, taking out a (usually low cost) loan to acquire this asset that will increase in value is generally considered a pretty good bet. Other examples may include a business loan to expand production capacity, or student loans. Taking on debt for assets that decrease in value is generally considered to be bad debt. The quintessential bad debt example is credit card debt - once you’ve purchased something on your card you’re unlikely to get more value for it but by not paying the balance off you’ll wind up paying significantly more than the cost of the item. Store credit cards, rent-to-own financing, and even car loans can be examples of this. Much like how what is a need or want can vary between families, whether something is an investment or a sunk cost will vary as well and what may be bad debt to some may not be for everyone - but it’s important to look at any balances owing and determine honestly if you’re investing for the future, or paying for your past.

Also important when considering your debt load is interest rates. Essentially, when you want to buy something that you can’t afford to purchase outright, an institution will lend you the money to buy it, so long as you promise to pay them back plus a fee for them providing you with the liquidity, and compensate them for the risk you won’t pay them back. This liquidity + risk fee is the interest rate. While most types of loans have a range of rates they will fall in, generally no two people will have exactly the same rate, because of that risk of repayment factor. If you have a history of not paying your bills in a timely manner, or are taking on enough debt that one missed paycheque will throw off your plan - you are riskier and whoever is lending you money will want a higher rate to get them to ‘invest’ in you.

To figure out where you should be focusing your energy, make a list of all of your outstanding balances - mortgage, car payments, student loans, lines of credit, credit cards, absolutely everything. Note the bill, the monthly payment, and the interest rate. Next sort these into two lists: your investing into the future list (that you will focus on later), and your paying for the past list.

Start with the paying for the past list (incidentally, these usually have higher rates) - credit cards, a home repair that you financed with the company, or a vehicle payment. If you are the type of person that gets a motivation boost from crossing one off the list, see if there is a relatively small balance and tackle it first (debt snowball method).

I personally like to then sort by interest rate and pay the most expensive debt first (debt avalanche method). This is because any money you put towards interest is money you are paying purely for the privilege of having borrowed before.

Depending on how severe your debt load is, there are a myriad of ways to tackle this - from lightest debt load to most serious:

If you have a few high interest items but you have some available cash flow, pay more than your minimum balance. If your credit card statement says the minimum monthly payment is $60, pay $100 if you can. Your statement will also show you how long it will take you to pay the balance by only paying the minimum, and it’s generally a pretty shocking number. This can shave months or years off your repayment time and thousands of dollars in interest.

If you have a few high interest items, but you have no/little free cash flow, work to lower your interest rate. Lowering your interest rate could be done by switching cards, or if you have a line of credit, paying your credit card off entirely with your line of credit. A word of caution, however, is that you will want to understand the terms and conditions before you do this as you aren’t eliminating your debt and a mistake here may actually wind up costing more. Sometimes a new card has a low introductory rate, but after 3 months it will shoot up, or being late on a payment moves you to a higher interest rate, or the way interest is calculated is less favourable - any of these can cost you if you aren’t aware of what you’ve signed up for. In addition, doing this too often can have a negative impact on your credit score, impacting your cost of borrowing in the future. Done carefully, however, this can reduce your required monthly payments so if you were previously paying your

minimums, you could now pay the same dollar amount but be eating away at the amount you owe.

If you have a lot of high interest debt, and you are struggling to meet your minimum payments, start calling providers. Generally speaking, someone that has extended credit to you wants to get their money back. If you just stop paying, they will sell your debt to a collector for a fraction of its value, and then they wash their hands of it, leaving the debt collectors one goal - to get more money from you than what they paid. Before you reach that point, creditors will have incentives to work with you, as they may not get everything they are owed, but they’ll do better than with the debt collector, and be more pleasant to deal with for you. Call them, explain that you’re having trouble making your payments but that you want to get everything sorted out and see if you can get reduced interest rates, or stop accumulating interest as long as you meet a minimum payment. If you don’t know where to start with this, there are credit counselling services that will work with you to determine if you can tackle this on your own, help you with conversations to creditors, or help determine if you need to look at more formal steps.

If informal discussions with creditors, or debt consolidation is not enough to resolve your issues with creditors, and the amount owing is less than $250,000 you may want to consider a Consumer Proposal. This becomes a more formal process, and is governed under the Bankruptcy and Insolvency Act. You will work with a trustee to prepare a plan to repay a certain percentage of your debts over a set time frame, and this plan is submitted to your creditors. If accepted, the trustee will manage your payments to the creditors. If the total debt owing is over $250,000 there is a process similar to a Consumer Proposal, but there must be a meeting with your creditors as part of the proposal process and the proposal must be approved by the courts.

If your Consumer Proposal is not accepted, the final option is to declare bankruptcy. There are some required forms to fill out with your trustee, to officially declare you bankrupt. From this point onwards, your trustee will deal with your creditors, help you meet your payment obligations, and walk you through things like what assets are protected from liquidation, and which debts will not discharged with your bankruptcy. Once your legal obligation to repay your debts is over, you can file to have your bankruptcy discharged. If you think you may need to enter into a Consumer Proposal or Bankruptcy, you should consult with a Financial Counsellor or Bankruptcy Trustee to determine what the best course of action is for you, as this is a complex process that requires extensive knowledge in this area.

It’s also important to note that often, we feel ashamed to say when we are struggling, especially when it looks like those around us are succeeding

and living the good life. The pressure to “keep up with the Joneses” can definitely cause people to live closer to the edge of their means than they would otherwise. According to Stats Canada, the average household owes $1.71 for every $1 earned in income. Unfortunately, all too often ignoring the problem only continues to make it worse, and also compounds the stress level associated with it. If you are concerned about your debt, talk to a trusted financial advisor, or call a financial counselling service to help you take the first step to get back on track.

Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada.  She is also a licensed insurance broker in Alberta, Ontario and PEI.  While every effort is made to ensure the accuracy of statements, errors may occur.  If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations.