Are you feeling sluggish and depressed? Can’t get your savings to grow? Is your debt overweight? Then try this – the Debt Diet. Stick to it for one month and you may feel virtuous because your debt doesn’t increase. You could start to see results in as little as three months and after a year you could look back at your former finances and ask yourself “why didn’t I do this sooner?”
Snacking on chips is OK. Using them as a meal replacement – not so good.
The same is true of credit cards. Just as a bag a chips can jeopardize a diet, a credit card can lead you to incur out of control debt. They both take the waiting out of wanting; but at what cost?
If you see a $100 coat on sale for 25% off and you know you will have the money to pay for it within a month, then you can buy it with your credit card and save $25. But if you buy it and then don’t have the funds to pay later, you may have to carry the balance on your credit card, paying up to 29% interest. Each year it could cost an extra $21.71. Not such a “bargain”.
The same transaction can be either good debt or bad debt depending on whether or not you can manage that debt.
The largest debt that most Canadians take on is their mortgage. Like the example above, a mortgage can be either a good or bad debt, and in Canada we have strong banking regulations to help ensure that the debt is manageable.
First the lending institution checks that you can afford the payments. They look at something called Total Debt Service Ratio (TDSR). This ratio adds up all your debt payments; car loan payments, credit card payments, prospective mortgage payments, utilities and property tax payments and divides that total into your gross household income (before taxes and deductions). It is recommended that your TDSR should not exceed 44%¹.
The lender also has a minimum down payment requirement. For mortgages where the down payment is less than 20% of the purchase price, a high ratio mortgage insurance premium is applied through insurers like Canada Mortgage and Housing Corporation (CMHC). Although this is an added cost to borrowers, it allows Canadians with modest down payments to enter the housing market earlier, helping them build equity and financial stability.
When Mark Carney, Governor of the Bank of Canada, was in Nanaimo BC this October he stated
“Canada’s public finances are sound. Monetary policy is clear and credible. Canada’s financial system showed itself to be among the most resilient in the world through the crisis. Since then, it has strengthened further.”²
Using the following discipline, your finances could also be sound.
Take a look at your TDS and aim to reduce it to an “ideal” weighting of 40%. You can use a two pronged approach to do this.
First, work on a plan to decrease the amount of interest you are paying. Apply for a consolidation loan from your bank and pay off the balances of your credit cards. The interest rate on the loan should be lower than what you were paying on your credit cards, so if you leave your regular payment amount the same, more of your payment will go towards paying down your debt. Cancel credit cards with high interest rates and no benefits (for example, no loyalty points). Keep one or two cards for emergencies and if you don’t trust yourself to not use them, put them in a bag of water and freeze them! That should put a little waiting back into the wanting.
Second, see if there is a way to increase your household income. Are you at a point in your career where you can ask for a raise or apply for a new, higher salaried position? Should you consider getting a second job? If you are a two income household, you could aim to have your TDS be less than 40% of one of the salaries. This would give you the luxury of having a second income that can be used for extras or for emergencies.
There are different types of credit protection insurance that can be added to loans and credit cards to protect you in the sad event of loss of income or life. Your lender can provide you with details about this.
Just like a diet where you need to monitor your food intake, your debt needs to be monitored by controlling your payments in relation to your income.
With discipline, the debt diet could eventually lead to true wealth which, in my opinion, is having more income than expenses.
**This article was originally published in our Winter 2013 Issue**
This article was prepared by Elizabeth Summers, who is a Financial Planner with TD Waterhouse Financial Planning, a division of TD Waterhouse Canada Inc. and a subsidiary of The Toronto-Dominion Bank. TD Waterhouse Canada Inc. – Member of the Canadian Investor Protection Fund
The information contained herein is for information purposes only. The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. The information does not provide financial, legal, tax, or investment advice. Particular investment, trading, or tax strategies should be evaluated relative to each individual’s objectives and risk tolerance. TD Waterhouse Financial Planning, The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered.
¹ Canada Mortgage and Housing Corporation
² Bank of Canada Monetary Policy Report, October 2012