Michael Lawrence, CFP®, CIM® - Sr. Advising Specialist
Living with debt can be stressful, especially during high-inflationary periods where it can be more difficult to find extra money to put toward debt repayment. The FP Canada Financial Stress Index tells us that 38% of Canadians report that money is their greatest source of stress, and 39% of Canadians are tackling that stress by paying down debt.1
In the current rising-interest rate environment, the required payment on variable rate debt will either increase or become less effective. This is because when rates increase, the amount of interest incurred between payments also increases, so even though the payments might be the same, the amount of the payment that goes towards principal on the loan has decreased. Lines of Credit (LoC), Home Equity Lines of Credit (HELOC), and variable rate mortgages are all examples of debt subject to the movements of the prime rate. If you hold these types of debt, you may want to evaluate if holding the debt still makes sense or if you should prioritize paying it down.
Debt repayment example
Below is an example of an individual with debt. In this example, let's assume all their monthly essentials are looked after (rent/mortgage, groceries, utilities, insurance, etc.) and they have $1,200 remaining to allocate to five debts.
After making the minimum payments of $765, how should they allocate the remaining $435?
There are three primary methods to tackling debt:
The snowball method: This method focuses on paying off the smallest debt first. The goal is to reduce the number of creditors and to provide the debt payer with a sense of accomplishment that will help keep them motivated. Like a snowball, the effects of each payment are small at first, but as they pay off debt and eliminate creditors, they can then allocate the savings to the next smallest debt, which compounds the impact. Using this method, they would make all minimum payments then pay down the Line of Credit (LoC). After the second month, the LoC would be eliminated, and the minimum payment of $10 could be added to the $435, increasing the remaining amount paid towards debt each month to $445. They would then work on paying down Credit Card 1.
The avalanche method: This method aims to reduce the amount of interest paid and therefore increase the amount of debt payment that goes towards principal. With this method, they would make all minimum payments and allocate the remaining $435 towards Credit Card 2, as this debt carries the highest interest rate. Once Credit Card 2 is paid off, they would take the $435 and the $75 saved from the card's minimum payment and allocate this to Credit Card1. You can see that this method incorporates the snowball method but differs in which debt to repay first.
Debt consolidation: Debt consolidation can be a great tool for individuals with multiple creditors that are serious about repaying debt. With the above example, there is $7,000 available on the LoC, at a rate lower than both credit cards and the Personal Loan. Under the debt consolidation strategy, they would borrow $5,500 from the LoC to pay off both credit cards. They could take this one step further and make a one-time pre-payment to the personal loan of $1,500, thus maxing out the LoC, and increasing the minimum payment from $10 to $75. The savings from the credit card minimum payments ($35 + $75 = $110) would more than cover the increased LoC payment and the difference can be used to continue paying down the Personal Loan. Once the Personal Loan is paid off, they would start paying off the LoC (next-highest interest rate).
While the three debt strategies focus on debt reduction, not all debt is created equally and may have special status that could make paying it off less advantageous; even if it has a higher interest rate or is a smaller value. Some examples include:
- Tax-deductible debt: If the interest on the debt is tax-deductible, the after-tax cost of the debt may not actually be that high. For example, a taxpayer in a 43% marginal tax bracket, paying 6% of tax-deductible interest, has an after-tax cost of debt of 3.42%.2
- Student debt: Some student debt comes with an interest-free grace period of six-months where no interest is charged on the loan.
- Medical training debt: In the terms of the contract, it may state that the debt does not need to be repaid right away or in some cases, at all. An example of this could be an interest-free grace period or what is known in the medical field as a 'return of service' arrangement.3
It is important that those who take on debt read and understand all the terms associated with the debt vehicle as to not accidently violate the terms. A strategy for repayment should be created that works best for the borrower and the type of debt they have.
Debt as a tool
A Line of Credit can be a useful tool. It can be used in place of an emergency fund in situations where there is a loss of income or larger-than-anticipated expenses. It can also be used to consolidate debt like our example above or it could be used to fund larger purchases when the benefits of using debt outweigh the costs of tapping into savings or investments. With a LoC, interest is only charged on the balance owing and there is no fee for keeping it open “just in case.” The LoC interest rate is tied to the banks' prime rate and is usually quoted as the prime rate + x%.
A Home Equity Line of Credit is essentially borrowing against the equity that an individual has in their home. Every mortgage payment consists of principal and interest, and as they pay down their mortgage, they build equity. Depending on their circumstances and risk level, it may be a suitable strategy to use that equity to consolidate debt, fund short term purchases or invest.
Your Edward Jones advisor can help you manage your money by working with you to understand what's important to you. Your advisor can help you understand the broader picture and together, you'll be able to develop a plan to help you achieve those goals.
Important information :
1. FP Canada
2. Calculated as 6% x (1-43%).
3. A Return of Service (RoS) arrangement requires a recent medical resident graduate to practice medicine in a rural or underserved community for a specified period.