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Owing, in large part, to nearly seven years of ultra-low interest rates, low-barrier borrowing and the relative affordability of credit, Canadians are further in debt than ever before. The average non-mortgage consumer debt – including credit cards, loans and lines of credit – is currently over $22,000. Stated another way, for every $1.00 of disposable income (money remaining after bill payments) an average Canadian earns, they owe $1.65 in debt – an increase of nearly 20% in the past ten years.
When the Bank of Canada’s key interest rate was hovering between 0.5% and 1%, the rationale for carrying so much debt was easier to justify. Monthly payments were relatively low, meaning most people could comfortably pay their bills on time, make contributions to the principal value of their debts and still have money left over for other spending goals. However, as interest rates shift upward, many are realizing their free-flowing spending habits may have placed them in a compromising situation.
If you carry a balance on any credit device which uses a variable interest rate – be it a credit card, mortgage, line of credit or loan – you’ve likely already felt the pain of recent increases.
For example, if you have a $500,000 mortgage and your interest rate went from 2.5% to 3%, you are now paying an additional $126 per month. While the time it will take for you to pay off your home will remain the same, the share of your monthly budget dedicated to mortgage payments has gone up – leaving you with less money to pay down other debts, to spend on groceries or to put into savings.
If the rate were to increase by another 0.5%, that would leave you with $257 per month less than you had to work with at the beginning of the year. If you’re one of the 50% of Canadians who are less than $200 from not being able to meet their monthly financial obligations, that would place you in the difficult position of not being able to pay your bills.
Regardless of whether you are applying for a mortgage, loan, line of credit or a credit card, anticipating potential fluctuations in interest rates and simulating worst case scenarios is essential for protecting yourself and ensuring your situation never spirals out of control. If what you can afford to pay now is all you can afford to pay, you may want to reconsider whether taking on debt is the right decision. In fact, recent changes have been made to Canadian mortgage law to this effect. Legislation now requires lenders factor in a prospective buyer’s capacity to make payments at higher interest rates as part of the approval process.
It is also important to consider how taking on additional debt will affect your ability to keep up with your existing debt. If interest rates rise and income and spending remain the same, the difference needs to come from somewhere – and it’s often through credit cards, lines of credit and payday loans. You may tell yourself it is only a temporary solution and that the ends justify the means. However, thanks to the cost of borrowing, that’s rarely the way it works out.
Continuing with the example above: Assume you are now $57 per month overbudget. You decide to use your credit card – which has a 19.99% monthly interest rate and an existing balance of $5,000 – to cover the difference. You’ve already budgeted $100 per month toward your balance and know it will take you nine years to pay off at that pace. After one year, your balance will increase by $532, your interest costs will increase by more than $170 – almost enough to offset a month of increased mortgage payments – and you will slash the portion of your payment going toward your principal by almost a third. It would take you nearly four additional years to pay off your credit card debt, provided you stop using it immediately. However, if you continued for just nine more months, your balance would increase to over $6,000, you would no longer be able to afford the minimum payments and it would take you more than 25 years to pay off the balance.
Remember, interest charges are calculated as a percentage of your total debt burden. Therefore, the more debt you add, the exponentially higher the cost of borrowing will be and the more difficult it becomes to reign it in. If you cannot increase your monthly payments to offset both the added debt and the added interest, continuing to use credit is certain to make a catastrophe of an already difficult credit situation.
To understand whether you can afford either new or existing debt, ask yourself the following questions:
If you’re looking at your interest rates and worry about how an increase would affect your bottom line, it may be time for some changes. If you have any variable rate debts, now is a good time to lock them in. If you don’t have a budget, creating one will be a priority. If you do, try using it to review a variety of situations. You may identify areas that can be cut or scaled back to make up for increased interest payments and still make payments on the principal value of your debts.
If you worry taking on more debt is the only way to offset the rising costs, there is another way. A Licensed Insolvency Trustee can help you find solutions and put you on the path to a debt-free future. Call MNP for a free consultation and discover which life-changing debt solution might be best for you.
Based out of Kelowna and Vernon, Jeane Herman is a Licensed Insolvency Trustee and Senior Vice President at MNP LTD. To learn more about how MNP Debt can help, contact our local office at 1.877.898.2580 or toll-free at 310.DEBT (310.3328).
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