Almost every Canadian household has some form of debt or another. And while taking on debt has become a part of Canadian life, it’s important to have a thorough understanding of your debt situation, and where it is taking you. Many of us have debt products thrown at us (every month I get blank cheques in the mail from credit card companies telling me to spend, spend, spend!) and knowing what to do takes education and discipline.
I like to keep things simple, in my mind there are two broad categories of debt – Good Debt and Bad Debt.
Good Debt: Includes a reasonable mortgage, investment debt and student loan debt. Of course, there are limits; here are some notes on each one:
- Mortgage Debt: This should be less than 3X your annual salary. So if you/your family earn $100k per year, your max mortgage should be $300k. Note there are some minor exceptions here, but this is the rule of thumb I follow myself.
- Investment Debt: Borrowing money for stable investments, especially when invested in an RRSP, can make a lot of sense. Note that you should be paying this loan back by the end of the current year.
- Student Loan Debt: Borrowing for your education is good, provided the program has employment potential and you can pay off the amount borrowed in roughly 5 years.
Bad Debt: We all know when we are spending above our means…if you can’t buy it with cash, should you really be buying it at all? Bad debt includes the following:
- Consumer Debt: T.V.s, vacations, clothes, kids’ toys, and any other item that is not a necessity (i.e. food, shelter or water).
- Too Much Mortgage Debt: Any mortgage over 3X your annual salary is leaving you very exposed to interest rate changes. I know several people with an $800k or higher mortgage… If interest rates go to 6%, it literally doubles the required monthly payment. Can you afford your mortgage to double? I will be doing a separate blog on interest rates in the coming weeks.
- Frivolous Student Loan Debt: If you are uncertain your education will get you a job, do not borrow money to fund it. Now, I am not saying a Fine Arts Degree isn’t a good education, but I am saying don’t borrow money to do it. I have met countless 30-somethings still paying off an education they didn’t really want/didn’t really use and, of course, they now wish they never went to school. Universities and colleges are in the business of graduating students and not necessarily in the business of helping you get gainful employment.
Our current spending culture is a “now” culture — we want instant gratification to satisfy our cravings. This impulsive and unprepared spending can lead to bankruptcy, especially if you are faced with a sudden change in income. Being disciplined is hard (I struggle with it from time to time as well!).
When reviewing your debt, here are a few things to ask yourself:
- How much do you annually spend on interest? Take a deep breath, sit down and add it up. If you pay more than $10,000 of annual interest, that is an absolute sign that you have acquired too much debt. Imagine what you could do with another $10,000 of cash?
- Are you paying your credit card bill off entirely, every month? If not, then why are you spending more than you earn? That is a good sign that you are acquiring too much material debt.
- Keeping track of your net worth year over year can also give you an idea of your debt. Your net worth is your assets, less liabilities — year over year. Is your net worth getting bigger or smaller?
Those are all ways to give yourself a quick and healthy self-review of your debt so that you can better take control of your debt and, ultimately, your financial future. Interests rates usually only go one way — up. A 1% change in interest rates can create a significant bump in your monthly payments, as outlined in the chart below.
$500k mortgage, 25 years at 3% = $2,366 monthly payment
$500k mortgage, 25 years at 4% = $2,630 monthly payment
$500k mortgage, 25 years at 5% = $2,908 monthly payment
Could you handle a $300 – $600 increase in your mortgage overnight? Canada is a country that has been spoiled by low interest rates for more than a decade. Many experts are predicting an interest rate bump of 2% within in the coming years. You need to have a financial plan that clearly shows what your income, expense, investment and debt horizons look like so that you can determine if your spending is taking you down a path that is unwise.
It is critically important that you gain a handle on when you will become debt free. Entering retirement age with any debt will significantly limit your ability to have a comfortable retirement. In my opinion, a healthy retirement starts with roughly $2,000,000 in an investment account and no debts at all. Of course, there are always exceptions; give me a call and we can discuss your personal situation.
Disclaimer: Tax and legal rules change frequently and can depend on your individual circumstances. The above is not to be relied upon as legal nor tax advice and is meant for information purposes only. Please consult a legal and/or tax professional.