Digging into the Details of your Debt
02 November 2022 1
02 November 2022 1

You don’t have to look at the news for very long before you see a headline about the debt problems of the average Canadian – and the numbers can be quite shocking!

• Average consumer (non-mortgage) debt: $21,000

• Average household debt to disposable income: $1.82

• Most indebted age group: 46 to 55 years ($36,241 non-mortgage)

• Average credit card debt: $5679

The only positive has been that over the past couple of years, carrying debt (credit cards aside) in Canada has been pretty cheap. Anyone with access to home equity could have easily cashed in on rising house valuations and gone on a major spending spree at a pretty manageable cost somewhere between 2% and 3%.

Unfortunately, the consensus now is that those rates were once-in-a-lifetime bargains and aren’t likely to be repeated anytime soon. Interest rates have already risen sharply in 2022 and we are not through yet. The Bank of Canada overnight rate which is used as the benchmark for most loan agreements has risen from 0.25 % at the start of 2022 to 3.75% in October and is likely to rise again in December.

Despite the daily headlines about rates rising at a record clip, many people remain in the dark about just how much they are paying (or will soon be paying) to service their debts. Part of the reason for our nonchalance might be that we have all forgotten how interest (both simple and compound) can add up!

Car loans are a good example. The days of ultra-cheap financing have all but disappeared and according to Stats Canada the average car loan is now at 6.62%. While a lot of us can borrow at a lower rate depending on our credit score and the dealership, a 7-year loan on a $35,000 car at 5% is going to cost you $6554 in interest charges. Shortening the term to 5 years (what used to be the norm for car loans!) will reduce that down to $4630 and save you almost $2000 in interest charges.

Before you convince yourself a shiny new ride is well within reach by simply adding a couple of years to the financing term, make sure to calculate and then rationalize the added interest cost, not just whether the bi-weekly payment is do-able. Don’t forget to factor in depreciation (currently very low thanks to the shortage of cars) as well as the total operating costs including gas, insurance, parking, tires, oil changes, car washes, etc. — which are getting more expensive by the day!

If you do the math on your house, the pain is much worse, and you need to start budgeting for when your current mortgage agreement expires. If you are renewing a fixed rate mortgage from 5 years ago, you are likely looking at somewhere around 2% more. On a 25-year, $400,000 mortgage, moving from 4% to 6% will cost you about $500/month more. If you have a variable rate mortgage, you have probably seen it increase by the full 3.75% increase this year and that works out to a bump of almost $900! If you have a variable rate mortgage with a fixed payment, you are in for a huge increase and you may have to adjust your amortization schedule when you renew as your current payment may barely be covering the interest.

Home equity backed lines of credit are another area where borrowing costs have increased dramatically and will very likely continue to rise. A quick Google search shows these rates are now hovering in the mid 5% range, about double what they were 2 years ago. We agree that not all debt is bad, and home equity is often a great option to draw funds and pay down higher interest debts. However, it is no longer a source of super cheap cash for vacations, home renos, cars, furniture, etc.

If you are eyeing home equity to fund a $100,000 kitchen and bath renovation for example, make sure the accompanying $5500 in annual interest expense (assuming you pay interest only) is within your means. Also ensure you fully understand the terms and conditions for repayment and have a solid plan in place for paying it back and/or refinancing. Don’t forget that interest rates are most likely going higher and home prices may continue to fall — a double whammy that would easily slam the value of that $100K kitchen investment and put it way underwater very quickly!

The perils of credit card debt are well documented, but it bears repeating as the average Canadian owes their card company around $6000. Not all credit cards have high rates, but most are pushing 20% and even “low-rate credit cards” are seldom below 10%. The good news is that credit card rates don’t usually move with other interest rates and are bound by your cardholder agreement, so you may not see much change. The bad news is that credit cards are quite unique in that the interest charges are compounded daily, and the minimum monthly payments are shockingly low.

Paying the 3% minimum on a $1000 balance at the usual rate of around 20% will take around 11 years to pay off and cost you another $1000 in interest charges. Even the so-called “low-rate” card at 10% interest will require almost 8 years before you eliminate the balance. Paying the minimum balance on a credit card is an almost a never-ending debt cycle. Adding even a small amount ($50) to the minimum can make a big difference — learn just how much here.

Student loans are another type of debt that could see a dramatic increase when the interest-free period imposed during the pandemic on Canada Student Loans (federal) comes to an end in March 2023. If you elected to pay back your student loan at a fixed rate (prime +2%) you were likely paying around 4.5% in April of 2021. Based on current interest rates (which are expected to go higher] the interest rate on your Canada Student Loan will rise to almost 8% when the interest resumes in April of 2023. There has been some talk of loan forgiveness programs, but the current Repayment Assistance Plan is quite limited, and nothing has been announced so far on any other assistance programs.

A lot of people struggle with debt because they don’t really understand the details. Do yourself a favour and take the time to learn why paying the minimum on your credit card balance is futile and costing you a fortune, or how those fixed payments on your variable rate mortgage are fast becoming a huge liability as interest rates rise.

Not all debt is bad and it is a fact of life if you are eyeing a new car or buying a home. However, that’s no excuse to sign on the dotted line without fully understanding your obligation to repay that money an under what terms and conditions. There is no way to reliably forecast which way interest rates may go but they were historically low through the first quarter of 2022, and it isn’t likely they will be returning to those levels anytime soon — understanding the details of your debt will help you cope with future changes and find solutions.



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MarkPparker
Nov 02, 2022 09:52:09

Well said!

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