Debt is like quicksand. It can be very hard to get out of it, but if you don’t do anything you’ll remained trapped. If there’s one thing consumers that are deeply in debt can take solace in, it’s that they’re not alone. According to the Certified General Accountants Association of Canada, household debt in Canada hit a record-high of $1.5 trillion during the first quarter of 2011. In the first three months of 2011, Canadians borrowers $0.49 for each dollar spent. The report also found 57 per cent of Canadians used credit to pay for daily living expenses, including food, housing and transportation.
What is debt?
Debt includes any money that has to be repaid – credit cards, personal loans, student loans, money borrowed from friends or relatives – you get the idea.
But there is a difference between good and bad debt. Good debt allows you to buy assets that will appreciate in value over time or provide you with an income stream. Bad debt is money spent on depreciating consumer goods.
Lenders make significant amounts of money from people who use credit. And while it can be beneficial for you to put purchases on plastic at the time, make no mistake it’s the lender who really benefits. Joining fees, access fees, interest fees, application fees – they have lots of ways to make money off of you, even if you never use your card.
Getting rid of debt
While it’s easy to accumulate debt, it is not that easy to get rid of it. There are several traps that should be avoided when trying to reduce your overall debt:
Consolidation is not all it’s cracked up to be. When you consolidate, you gather all your debts into a single loan with an affordable repayment. While this can make it easier for you to pay back your loan, you will end up stretching out the debt for a longer period of time. What this means is that in the long run you will pay considerably more in interest. You might also be required to provide security for the loan.
One alternative to this “solution” is to work out a budget you can live with and concentrate on eliminating your smallest debt first. Once you’ve gotten rid of that debt you can take that repayment and add it to the next smallest debt and start paying it off. This “snowball” method of repaying debts is very effective.
These offers prey on consumers’ desire for instant gratification. If you really can’t wait to save and buy the item, then at least walk into the deal with both eyes open. Usually the “interest-free” loan contract is for a set period of time, for example 36 months, and consumers are sent a monthly statement with an “amount due”. You could be fooled into believing that in 36 months the loan will be fully repaid, with no interest owing – but that’s not the way it works. The minimum amount on your statements is only a small percentage of the balance – about 3% of the total. So if you fail to clear the entire payment by the end of the interest-free period – you will then be charged interest on the outstanding amount.
So if you’d like to take advantage of these offers, the best thing to do is ignore the minimum payment and divide the total cost by the number of months in the interest-free term. This amount is what you actually need to pay monthly to avoid being charged interest.
Homeowners are often tempted to use the equity they’ve built up in their homes to pay off their credit cards. While it seems like a good idea to pay off a loan at 7 per cent, rather than a credit card at 18 per cent, it’s actually false economy.
It only makes sense to roll your credit card debt into your home loan if you are able to repay the combined debt faster than the original debt. For example, if you have a personal loan of $100,000 for three years at 14 per cent and a $150,000 mortgage at 7 per cent with 20 years, you can the $10,000 and pay it off, but that $10,000 will now cost you $6,300 more in interest payments than if you had just stuck to the original terms of the loan.
Revolving debt vs. fixed term credit
Revolving debt requires minimum payments that mostly cover interest and only postpone repayment of the expanding debt principal. Examples of revolving debt include lines of credit and credit cards. Personal lines of credit have 60.1 per cent of Canada’s personal lending market share. While credit cards are the fastest-growing type of personal debt in the first quarter of 2011 – up 5.8 per cent. Revolving debts should be at the top of your list in terms of repayments.
Fixed-term loans, on the other hand, are usually small with a fixed repayment schedule. The benefit to the borrower is certainty over loan repayments. The one thing to watch with fixed-term loans, however, is that they are expensive and the set-up costs can be more than actual interest to be repaid.
Getting back to black
Step 1: Write it down
Try this exercise for one month – write down everything you spend money on. You might be surprised to learn how much you actually spend in a day on incidentals. Many people have absolutely no idea how much money they waste, because they simply do not think about it. By writing it down, you can see where your money is going and what areas you can easily cut back on spending.
Step 2: Make a plan
You can’t just wave a magic wand and make your debts disappear. Reducing your debt is like losing weight – you need to attack it on two fronts. To lose weight you need to exercise and eat less, to lose your debt you’re going to have to embrace a lifestyle change and cut back on spending.
Part of making a plan, involves doing a budget. This isn’t as painful as it sounds. Calculate what money is coming in each month and how much you need to spend to cover your basic costs of living. Then take 15% and put that towards your debts. Depending on the size of your debts, you may even have to go higher.
Find out exactly how much you owe, and how much you can pay back each month. Focus on the smallest debt and pay it off more aggressively than the others.
The best thing you can do is take some responsibility for your debts. Once you tackle the problem head on, you’ll find it really isn’t as scary as you first thought.
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