New Year’s debt resolutions
It’s an extreme example of the old saying that, just because someone is willing to lend you money, it doesn’t mean you are smart to borrow it.
The BBC reported earlier this month that Luke Brett Moore, an unemployed young Australian, discovered that his bank had accidentally given him, in effect, an infinite credit line. The BBC headline sums up well what happened next: “The bank lent me $2 million so I spent it on strippers and cars.”
You don’t need to be a bank credit analyst to guess that he didn’t pay the money back.
I am assuming most Yukon News readers like you are not in the middle of a $2 million binge on strippers and cars. If you were, our newsroom would have heard about it by now.
But do you ever ask yourself if you have, maybe, borrowed too much money?
There are almost certainly readers in this situation. The Globe and Mail recently reported the number of Canadian households that owe more than 3.5 times their gross incomes has doubled since the financial crisis. Almost three-quarters of a million households are this deep in debt.
The paper’s finance section has created a handy online survey which helps you calculate your “Real Life Ratio.” This calculates how much of your “take-home pay is left after meeting a full range of household costs and putting some money away in savings,” including costs like utilities and daycare. Readers taking the survey were, on average, in pretty good shape . But beneath the average, 17 per cent had less than a quarter of their incomes left after the payments mentioned above. The paper describes this situation as financially stressed or on the verge of it.
The difference between the $2 million dollar man and most borrowers is that, for most borrowers, their bank didn’t make a mistake. The data shows that Canadians, even when relatively highly indebted, have low and stable default rates. They are highly likely to pay the money back. The banks have carefully developed financial models they use before approving a loan, and Canadian regulators have been pushing in recent years to make them even more conservative.
However, paying a big loan back usually means scrimping on other things. In the case of a mortgage with a 25-year amortization, it can mean scrimping on other things for a good chunk of your life. For the surprisingly large percentage of fifty-somethings who have piled consumer debt on top of their mortgage, it can mean a lifetime of debt payments.
The biggest financial decision in your life is usually your house. We’ve all heard stories from people who were surprised by how much their bank was willing to lend them. I know people who borrowed the maximum and those who took significantly less.
Consider a couple looking at a $400,000 mortgage. On a 25-year amortization, a five-year variable mortgage at 2.85 per cent would cost $1866 per month. They would pay $160,000 in interest over the life of the mortgage.
If they bought a house $50,000 cheaper, not only would they save $50,000 but they would pay $233 less per month and a whopping $20,000 less in interest over the 25 years.
Furthermore, if the $400,000 mortgage and its $1866 payment is on the edge of their comfort zone now, they should think about what could happen if interest rates go up. A lot of international economic mayhem can happen over 25 years. Already, the Federal Reserve in the US is signalling more rate increases in 2017. Who knows how long before the Bank of Canada starts following suit.
What if rates went up 2 per cent? This sounds like a lot now because we have become used to low interest rates. But ask someone who had a mortgage in the 1980s how much they liked paying double-digit rates. If the rate on that $400,000 mortgage went up to 4.85 per cent, the monthly bill would be $2304 and the total lifetime interest would be $291,000.
That’s a staggering $131,000 in additional interest costs.
Even if a person’s mortgage payments are bearable, consumer debt can push a borrower over the edge. Cars, trucks, trailers, sleds, kitchen renovations and vacations can push a household with a solid income into financial stress. Especially if it involves credit card debt with those punishing 20 per cent interest rates.
As Einstein noted, the world is divided into two groups of people: those who understand compound interest, and those who pay it.
The good news is that the sooner you start dealing with debt, the easier it is. The first thing to do is not to get over-extended in the first place. Think about choosing the smaller house, driving a smaller car and putting up with the ribbing because you’re riding an eight-year old sled.
But even if you already made those decisions, there are options. I’ve talked to a couple of Yukoners who downsized their homes early, and reaped the financial benefits. You can’t sell the vacation or kitchen renovation, but you can sell the seldom-used trailer or barely-needed 4x4. The cash can be used to pay down your credit line or mortgage.
Then, if you can economize in day-to-day life and increase your mortgage payments a bit, it can make a big difference. That $400,000 mortgage mentioned above ends up costing $17,000 less in lifetime interest if you pay an extra $100 per month from the beginning. It is also paid off earlier.
The new year is a good time for some debt resolutions. Even if you can’t bring yourself to put your 2016 Ski-Doo Renegade Adrenaline 900 ACE on Kijiji, at least go online and try the Real Life Ratio test at http://www.tgam.ca/realliferatio.
Keith Halliday is a Yukon economist and author of the MacBride Museum’s Aurore of the Yukon series of historical children’s adventure novels. He won last year’s Ma Murray award for best columnist.