Title: Managing your debt-to-income ratio.
By: Borzykowski, Bryan, Maclean’s, 00249262, 11/19/2012, Vol. 125, Issue 45
More Canadians are becoming overburdened with debt. According to the Bank of Canada, the household debt-to-income ratio (DTI) is 163%, which means that for every $1 of after-tax income, consumers owe $1.63. That’s a dramatic increase from 1985, when DTI was 73%.
And it’s not just mortgages. In August, credit reporting agency TransUnion said that Canadians owe, on average, $26,000 of non-mortgage-related debt, citing it as “the highest debt level per person seen to date.”
While the numbers may suggest Canadians are too levered, David Trahair, a Toronto-based chartered accountant and author of Crushing Debt: Why Canadians Should Drop Everything and Pay Off Debt, says not all debt is bad. Good debt, he says, can make you money over time, as in the case of a mortgage or student loan. Bad debt buys something that depreciates in value, such as a TV or a car.
Along with the type of debt, the age of borrowers can also be a mitigating factor. “If a 30-year-old has only mortgage debt, owing 63% more than annual take-home pay would be excellent,” says Trahair. “If it’s a 60-year-old who loves to go on trips and has high credit card debt, then that would be a terrible ratio to have.”
The climbing DTI ratio is partly attributable to rising home prices, up about 341% since 1981. But it’s also thanks to falling interest rates – which hit all-time lows this year, making debt seem less scary – and a consumer culture that glorifies indulgence.
That’s a bad combination. The Bank of Canada in late October stated explicitly that it will raise interest rates at some point and that it considers spiralling household debt to be an important factor that will lead it to do so. It’s a bald call for Canadians to rein in their spending and bring personal debt under control.
“The number one reason for bankruptcies is still consumer spending and a mismanagement of funds,” says Laurie Campbell, CEO of Credit Canada Debt Solutions, a not-for-profit credit counselling service. While anyone can wind up deep in debt, Campbell says seniors and newly graduated 20-somethings are most at risk. The 65-plus crowd increasingly supports grown children, and many haven’t saved for retirement. Younger people often have student loan debt; meanwhile, they have overloaded their credit cards, and their first jobs don’t pay enough to support debt payments and an overly extravagant lifestyle.
Credit card debt is the easiest to lurch out of control. Carrying a balance from month to month is expensive. Interest rates can reach 30%. The damage compounds if credit card debt – or any debt – is carried into retirement. “Debt has to be gone by the time someone stops working,” says Mathieu Paradis, a financial advisor with Wealth Strategies of Raymond James Ltd. It’s much more difficult to pay off debt after the paycheques stop rolling in.
Your magic score
A good reason to keep debt low is that too much leverage can affect your credit score. Having a good score makes it easier to get loans, mortgages or lines of credit, and it also gives you access to better interest rates.
Nadim Abdo, vice-president of consulting solutions at credit reporting agency Equifax Canada, says the average score is about 720 – scores range from 300 to 900- but people scoring below 650 are typically treated as higher-risk.
Several factors contribute to a low credit score, but the two big ones are missed payments and high levels of debt compared to income. Lenders report updates on your payment history, so if you fail to pay a credit card bill or miss a mortgage payment, Canada’s credit bureaus will know about it. When it comes to debt levels, you’re not penalized for having several cards or lines of credit, but you can get in trouble if your debt exceeds 50% of available credit.
“Not everyone whose debt exceeds 50% will go bad,” says Abdo, “but typically, people who max out all their credit facilities are the ones more likely to get into financial trouble.”
The downsides to a bad score are higher interest rates and perhaps not getting a loan at all. “The difference between a good score and a mediocre score could mean tens of thousands of dollars in interest payments,” says Liz Weston, author of Your Credit Score: How to Improve the 3-Digit Number That Shapes Your Financial Future. And it’s easy to ruin a good score. It only takes one missed payment to go from great to garbage. “A score you spent years building up can be decimated overnight,” says Weston.
However, you can reverse the damage with a year or two of careful debt and money management. Patricia White, executive director of Credit Counselling Canada, advises paying every bill on time, making sure you use no more than 40% of available credit, and applying for credit only when you really need it. Multiple credit requests – not including shopping around for mortgages and car loans – can lower a score.
She also cautions against cancelling a credit card that has a good credit history. Lenders like to see a track record of paying off your plastic. If you cancel a card, its credit history disappears. “Older accounts should be kept open,” says White, “and use them occasionally to keep the accounts active.”
Because a bad score has such serious consequences, Liz Weston suggests checking your credit report once a year, and definitely before any major purchases, to prevent any surprises. Both Equifax (http://www.equifax.ca/) and TransUnion (http://www.transunion.ca/) will send you a free report via Canada Post, or you can pay a fee to check your score online.
For several months now, financial experts, including Bank of Canada governor Mark Carney, have been telling Canadians to shed debt. When interest rates eventually climb, many debt-laden consumers will struggle to meet payments.
Reducing debt doesn’t have to be a painful process. The first step is to go to a financial advisor who will help you create a financial plan. While advisors can show you how to cut spending, they can also show you how to reduce the cost of the debt you are carrying, to make it easier to pay off.
Stephen Reichenfeld, a CFP, vice-president and private wealth counsellor at Fiduciary Trust Co. of Canada, says one option is to consolidate debt under your mortgage, which generally carries a lower interest rate than almost anything else. Reichenfeld suggests doing this just once – don’t keep adding to your mortgage, and don’t rack up more credit card debt after the plastic is wiped clean. “Get that lower rate,” he says, “but then you need to express better discipline.”
Another way to keep interest costs down, says Mathieu Paradis of Wealth Strategies, is refinancing your mortgage. If you’re carrying a five-year fixed-rate mortgage negotiated in October 2009, it’s probably at about 4.3%; it’s possible to get a five-year fixed rate for about 3% today. There may be fees associated with breaking a mortgage, he says, but most lenders will give refinancers a “blended rate” – a number between the old rate and the new one – without penalty.
If you have built up equity in your home, you could also get a secured line of credit, says Paradis. By backing the loan with that equity, you get a lower rate than what you’d get from a regular, unsecured line of credit.
Finally, if you must carry debt on your credit card, says Trahair, shop around for the best deal. Many no-frills cards now come with single-digit rates. “That could immediately save significant amounts of interest,” he says.
Whatever you do, now is the time to reduce debt. Interest rates have nowhere else to go except up, so the earlier you can live a debt-free life, or at least a low-debt one, the better. “Having no debt in retirement is the goal,” says Trahair. “It won’t be easy, but it can be done.”
DEBT MANAGEMENT APPS
Smartphone apps can help you manage debt and stay on top of your finances.
Mint Android/iOS – Free
Collect bank account and credit card information in one place. Create budgets and receive alerts when you exceed your set amount.
Debt Payoff Planner Android – $0.99
Sort debt by highest interest payment, lowest balance, minimum fee amounts and more. Enter monthly payments for each and see how long it will take to pay off
iReconcile iOS – $2.99
Input all account and credit information and generate interactive reports to see where your money is going.
Expense Manager BlackBerry – Free
Track expenses to see where you’re spending by week, month or year. Create pie chart and bar graph reports. You can also take images of bills for record-keeping.
By Bryan Borzykowski
Edited by John Southerst