Trying to save while you’re in debt is like trying to swim with your boots on. It’s possible, but it’s much harder than it needs to be. Suppose you want to save for a home, retirement, or even a vacation. If you’re in debt, for every dollar you save, you could lose a dollar or more in interest charges. That’s because the interest on many types of debt is higher than the return you can get by saving or investing.
And the longer you carry your debt, the higher the interest piles up. If you’re just paying the monthly minimum, you end up paying interest on the interest. It can be pretty discouraging.
Understanding the difference between good and bad debt
Here’s the first thing you need to know about debt: There’s good debt and bad debt. Good debt is money you owe for an asset that will grow in value over time. That’s often a home, but it can also be the cost of a college or university education. Your education will (you hope) cost much less than the amount by which it will increase your lifetime earnings. Bad debt is money you owe for depreciating (or even instantly disappearing) purchases, like clothing, travel and entertainment. But if your mortgage or student loan payments are crushing you, that’s bad debt, too.
Let’s talk about credit card debt. That’s the highest-interest debt that most people carry. It’s quite easy to get a credit card and even easier to run up the balance. What’s harder is paying for everything you’ve charged, every month. Today, major credit cards typically charge close to 20% interest on outstanding balances. They charge even more for cash advances. Most Canadian adults own at least one credit card; many have more.
Total credit-card debt in Canada rose on average by 20.7% every year for the two decades before the start of the pandemic, according to Statistics Canada. From February 2020 to January 2021, in contrast, total credit-card debt dipped by 18.3%. Why the big drop? During the lockdowns, there were limited opportunities to spend money.
“Many households used this opportunity to pay down expensive non-mortgage debt, with the balances of unsecured lines of credit and credit cards being paid down in record amounts,” says StatsCan. “With the economy now reopening, many Canadian households could find themselves carrying lighter non-mortgage debt balances than they had going into the pandemic.”
The “debt snowball” approach to credit card debt
What if you have several credit cards that you haven’t been able to whittle down? With some juggling, you’ve been paying the monthly minimums, but you’re afraid you’re going to start dropping the balls. Before that happens, try a debt snowball, which combines a little math with a dash of psychology.
Start by declaring a holiday free from plastic. Put your cards away somewhere safe. Delete your card numbers from your online shopping accounts – anything to make it harder to use them. Think of it not as self-denial, but rather as something good you’re doing for yourself. This will help you ensure the snowball rolls in the right direction – away from you and not towards you.
Figure out how much cash you have left over each month after paying for the absolute necessities. Calculate ruthlessly. Next, begin throwing every bit of that cash at the card with the lowest balance. Meanwhile, make the minimum payments on the rest of your cards. Keep it up every month without fail, until you’ve cleared the balance on that first card. Because that balance is the lowest, you can clear it the fastest. Celebrate your win by paying cash for a small treat, like a designer coffee.
Take what you were paying on card #1 and add it to the minimum payment on the card with the next-lowest balance. It will take longer, but you’ll feel that much better when you get that one down to zero. Celebrate with a slightly bigger treat, like a movie ticket.
Work on the account with the next-lowest balance until it’s clear, and so on, until you’ve cleared off all your cards. Congratulations! You are a money-management star! This time, celebrate with something a little more luxurious, like a pedicure, a massage or a barbershop shave.
How do you stay out of debt?
Now that you’re out of debt, how do you stay that way? One route is to get serious about sticking to a budget. Rather than adding one after another line item and then wondering how you will pay for it all, start at the other end. Take a clear-eyed look at your after-tax income, and work backwards. Deduct your housing costs, groceries, insurance, transportation and other essentials. Whatever is left – however much or little that may be – is your discretionary spending limit. When that amount is gone each month, take a deep breath and remember how good it felt to clear off your balance. Step away from your credit cards, and wait for next month. Another tip: Ask your financial institution to lower the limit on your credit cards.
Managing unexpected expenses
Staying on budget when you’re just faced with expected bills, like rent and groceries, is a very good thing. But what if your car breaks down, your furnace quits or your dog needs an operation? If you’re short of cash for something critical, there are better ways to get the money than putting it on plastic. If you have a good credit score, you may be able to arrange a personal or home equity line of credit. A low-interest line of credit can be a good idea for a couple of reasons.
You can use it to pay off your high-interest cards. And you can tap it for emergency funds as needed, at a much lower interest rate than a credit card. Again, though, don’t borrow more on your line of credit than you can pay off reasonably quickly. The rate may be low, but the interest will build up. Once you’re out of debt, make it a priority to have a cushion of three to six months’ salary in a bank account or tax-free savings account (TFSA).
Resist the temptation to take out a short-term payday loan to tide you over until your next pay cheque, . Introductory rates are often temporary and the real rate can be 25 to 30 times higher according to the federal government’s Financial Consumer Agency of Canada.
A credit card can be very convenient if you use it wisely. It saves you running to the bank for cash. It makes online shopping easy. And you can earn reward points for things like groceries and travel. But choose your card carefully. Pick a reward program that will give you something you actually need. And compare all the cards’ features, including promotional details, fees and penalties for missing payments.
Here’s the golden rule for using a credit card: Only charge as much as you will have cash to pay for when the bill comes due.
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Having difficulty getting out of debt? Our financial advisors can work with you to develop a plan that will get you back on track.