Month: June 2016

What Happens To Debt When House Prices Fall?

J. Douglas Hoyes

Posted in Assets & Property

Reading time: 30 minutes

Hoyes, Michalos & Associates Inc. - Hoyes, Michalos & Associates Inc. | Ontario Licensed Insolvency Trustees
House falling down to show housing bubble bursting

My guest on today’s podcast, Ben Rabidoux is the President of North Cove Advisors, a macro research firm that works with institutional investors like mutual fund companies, hedge funds, and pensions, providing a broad view of the economy at any time. Today he visits Debt Free in 30 to share his insights on the current status and future of the Canadian housing market.

The current housing boom is driving our economy

Construction employment, and employment in the FIRE industries (Finance, Insurance, and Real Estate services) are at an all-time high and represent a record proportion of GDP in most regions. These industries tend to cycle with housing so when they peak, so does the housing market.

Ben goes further giving two examples from the late 1970’s and late 1980’s, noting that there was a noticeable peak in residential investment, which is new housing construction and renovation, and commission paid to realtors. It’s percentage of GDP peaked at roughly 6.5% in the last 1970’s and 6% in the late 1980’s. Both peaks were followed by a very soft real estate market. He adds:

We just set a brand new record for residential investment; the percentage to GDP was 7.7%. We are way above where we’ve ever been in any previous peak. And so as an observer of that, to me it’s clear that there’s too much of the economy being driven by this… an economy that is too reliant on household borrowing and on building and selling condos to each other.

While housing prices are high relative to income, interest rates are low. If they remain low, Ben feels the boom could go on a while longer. However:

real estate is cyclical and we tend to forget that when we go through these long boom times…And the next cycle, whenever that happens, you know, there’s a lot of evidence to suggest that it’s going to be worse than some of the previous cycles.

Household debt is too high

Household debt is high by historic standards – roughly 165-175% debt to income. But Ben isn’t so concerned with the level of debt but rather what the distribution is within the average.

The bigger question is, what is the distribution within that average? So what percentage of households have 500% debt to income, 600% debt to income, and how has that changed over time?

The most recent financial stability review from the Bank of Canada found that the amount of highly indebted households have increased significantly since the early 2000’s, suggesting that there is a sub-segment of Canadians will be in financial trouble if interest rates increase or house prices fall.

In today’s housing market, the average debtor has several options should they find themselves in financial difficulty. They could sell their home, downsize, and pocket the difference, they can refinance or access additional credit secured by their home equity.

But what happens to debtors if house prices stagnant or fall? In a soft real estate market, their options start to disappear. They can no longer sell their home for a profit or refinance their mortgage to cover their debts. When house prices fall or stagnate, the arrears rate will jump. This was the exact scenario faced by US homeowners in the last US housing crisis.

Ben talks about the risks driving prices today, and whether or not they are sustainable including foreign investment, baby boomers cashing out and helping their children buy into the real estate market, housing starts and, of course, interest rates.

Thinking about entering the real estate market? Consider these points

  1. If you’re a young person and new to the job market, renting is a good option. If you’re a family with children, it becomes more nuanced.
  2. Look at what you can reasonably afford and try to have a 10-20% down payment.
  3. Don’t rush into the market because of FOMO – the Fear Of Missing Out.
  4. Be mindful of the industry you’re employed in – construction, finance, insurance, and real estate are cyclical and they haven’t seen a cycle in 20 years.
  5. Pay down debts aggressively.

Resources mentioned in the show:

FULL TRANSCRIPT show #94 with Ben Rabidioux

what happens to dent when the bubble bursts and house prices fall - fb

Doug Hoyes: Back in May on Show number 89, my guest was Hilliard MacBeth, the author of a book called When the Bubble Bursts – Surviving the Canadian Real Estate Crash. And in the acknowledgement section of that book, Hilliard acknowledges the contribution of Ben Rabidoux, North Cove Advisors, who provided valuable assistance throughout.

Well, I actually first met Ben last November, when we were both on a panel at an investment seminar, and I’ve wanted to get him on the show since then to talk about his views on real estate. Does he agree with Hilliard that the bubble is going to burst, or does he think that real estate will be a great investment in the future?

Well, let’s find out. Ben, welcome to the show, how are you doing today?

Ben Rabidioux: I’m doing great. Thanks for having me.

Doug Hoyes: Now, did I pronounce your last name correctly? Let’s start there.

Ben Rabidioux: You know, you’re one of the few who did – usually people kind of butcher that last name, but no, you did great.

Doug Hoyes: We got it good there – I think when we last met, you had to say it to me four times for me to get close there. So why don’t you give us a quick summary of what it is you do, you know, the company you work for, what exactly are you, what do you do that is related to real estate?

Ben Rabidioux: Sure. I started a company called North Cove Advisors, and basically we’re a macro research firm. We work primarily with institutional investors around the world, so you know, mutual fund companies, hedge funds, pensions, etcetera.

And yeah, I think I get most – I guess, mostly recognize me for my work housing, but that’s a relatively small part of what we do overall; we do – a broad view on the economy at any time. We do a lot of work on household credit trends, rates, currencies, etcetera. And then we’ve done some equities as well, so we do cover some stock names.

But I have a keen interest in real estate. It has been kind of a passion of mine for a while and I’m quite happy to discuss that or any other topic you want to chat about.

Doug Hoyes: Excellent. Well, let’s get right into it. And you are based in Ontario, is that correct?

Ben Rabidioux: That’s correct.

Doug Hoyes: So you understand, you know, what Canada is – obviously you’re looking at trends around the world, but you’re based here in Ontario.

So okay, well let’s get right into it then. What do you see as the future in Canadian real estate? And I understand that there’s no such thing as Canadian real estate. Obviously Toronto and Vancouver are completely different than, you know, let’s say Woodstock is, but in general, where do you see the world going – the Canadian real estate market going over the next – I don’t know, year, two, three?

Is it going to keep booming, is it going in the other direction, what’s the big picture?

Ben Rabidioux: Sure. I guess I should preface that by saying I certainly don’t have a crystal ball, and I have expressed concern related to housing consumer debts. It’s been several years now and I’ve been spectacularly wrong on that, so you know, I’m happy to offer a view on it, but like everyone else, it’s certainly not a perfect track record.

So look, my view is, I see a lot of areas for concern, and you are certainly right; we do not have a Canadian housing market. It’s very different by geography and certainly the Toronto single family market has a very different supply/demand dynamics than say Saskatoon. So no doubt about it, you can’t make broad statements.

That said, you know, we can observe a few things. One is, the economy in Canada – and this is really true of anywhere you look – the economy and the labour market in just about every jurisdiction, has been incredibly levered to this current housing boom. And so what I mean by that is, if you look at things like construction employment and employment in the FIRE industries, which are finance, insurance and real estate services, all-time high in just about every jurisdiction across the country. And they represent a record proportion of GDP in just about every jurisdiction.

And so those industries are obviously more than just housing. Clearly not all construction is building houses, not all finance employment is related to even mortgages, etcetera. But what we find when we look back over time, is those industries tend to cycle with housing, and when they peak, it generally corresponds with a peak in the housing market.

And so a great example – two great examples – in the late seventies and late eighties, we had a noticeable peak in construction employment. We had a noticeable peak in what we call residential investment, which is new housing construction and renovation and commissions paid to realtors – those three things are what we call residential investment, and its percentage of GDP. They peaked at about 6.5% in the late seventies, which corresponded with a housing boom in BC and Ontario, which subsequently resulted in a very soft market. And then they peaked again in kind of high 6% in the late eighties, which, you know, if you were a homeowner in Ontario in that time, you will remember that after the late eighties, through the early nineties, was a very soft market for real estate.

And so if you fast-forward today, we actually – we just had the latest quarterly when B2B Print came out, and we just set a brand new record for residential investment; the percentage to GDP were 7.7%. We are way above where we’ve ever been in any previous peak.

And so as an observer of that, to me it’s clear that there’s too much of the economy being driven by this, which means that there’s, you know, moving away from an economy that is producing good and services, to an economy that is too reliant on household borrowing and on building and selling condos to each other, and so that’s a concern.

And then, I guess, from the valuation perspective, house prices are very high relative to incomes, but there’s also the effect of very low – unprecedented low interest rates. I’m of the view that rates are going to stay low for a long time. I was probably one of the first people to really express the view that the interest rates in Canada were going to go substantially lower before they went higher, and that was back in 2012, and I’m still of that view.

So you know, we could see – look, this boom could go on for a while longer. Again, I don’t have a strong view on when this will ultimately end, but what I can say is – and it’s something that your listeners would want to keep in mind is, your real estate is cyclical and we tend to forget that when we go through these long boom times.

And the next cycle, whenever that happens, you know, there’s a lot of evidence to suggest that it’s going to be worse than some of the previous cycles. And I’m happy to talk about why that is, but you know, that I think is the big difference here between myself and Hilliard: I don’t have a strong conviction on when this boom unwinds. But we certainly share the view that when it unwinds, it’s going to be – probably going to be quite ugly.

Doug Hoyes: It’ll be spectacular. So you know, quite a number of points there, so let’s see if can kind of break it down. First of all, you said that you’ve been spectacularly wrong on your outlook over the last few years. And I’m exactly the same way; I mean, you go through the archives and look at what I’ve said on various news programs and interviews and so on, and I’ve said oh boy, you know, debt’s really high and it can’t go up forever, and then of course it does and it does and it does, and we’re at very high levels now. So we’re both in the same boat.

I think we agree that it’s a problem, but what we don’t know is when does the problem end? And with low interest rates, obviously I guess you can keep blowing up the balloon more and more. But let’s talk a bit about debt then, because after all, this show is called Debt Free in 30.

So what role does household debt play in all this? You know, give me your thoughts on that.

Ben Rabidioux: Sure. Look, household debt – I think everyone is quite familiar with the headline figures – 165% of disposable income. It’s a concern – it’s a real concern. Now, the counterpoint – and one you’ll often hear – again, the serviceability of that debt is reasonably benign right now. So in other words, when you look at the percentage of disposable income that families are paying to service like that, it’s high by historic standards – high – but it’s certainly not at all-time peaks.

And then on the flipside people will often say well, yes, we have a lot of debt, but we also have a lot of assets. I’m far less convinced that that’s a really sound argument, because at the end of the day the asset side of the balance sheet, often times it’s housing itself. And you typically – you know, in a down-market it becomes officially difficult to sell the house to settle your debts.

So it’s not like people can easily say oh well, I can just liquidate my assets to settle my debts – that doesn’t work in a down-market often times. So I mean, look, it’s a concern. To me, I think the bigger question is not what are the headlines – what’s the headline data, and there’s a lot of attention always every time we get a new Stat Canada print that comes out about, you know, the newest household debt levels, people always kind of freak out a bit about that.

To me it’s always what we call the tail distribution that matters, okay, and so if you think about what is the distribution of household debts? So if we assume that, okay, on average it’s to 165 to 170% debt to income.

So what does that mean? So that means on average people are owe $1.70 for every dollar of income they make. That in itself is not that concerning. If you picture someone who had that profile, that’s not a debtor that is in a lot of trouble.

Okay, so the average is not the problem. The bigger question is, what is the distribution within that average? So what percentage of households have 500% debt to income, 600% debt to income, and how has that changed over time?

So yeah, the big question is always, how fat is that tail distribution of risk growing and you know, we’re getting increasingly evidence, particularly out of the Bank of Canada in their latest Monetary Policy Report – I’m sorry, the latest Financial Stability Review – they did some great work looking at that exact question: what is the distribution debt, how has it changed over time? And they found exactly that, that the proportion of highly indebted households has risen dramatically since the early 2000s.

And so what that suggests is, you know, there’s a sub-segment of the population is going to be in real problems if interest rates rise, and I think the other part that people often miss is, there’s going to be a lot of people that get into trouble if house prices stop rising. This is a point I’ve made often times, I get a lot of pushback from people on this, but I often hear people say, you know, well, if you look at the arrears rate in Canada, it’s very low, so that means that people are managing their money well. I think that’s the wrong way to think about it.

And so people are often looking at the arrears rate as some sort of a leading indicator for the economy. It’s not, it’s not. And so I’ll give you an example of why that is.

So if you picture a borrower – let’s say a home buyer that just purchased a home two years ago in Toronto, okay, and let’s say that they lose their job today. In that two years, their house has probably risen by twenty to thirty percent in value, so if they can no longer afford their mortgage, they have options: they can either sell their house, pocket the gain and look for cheaper cost of living. Or they can, as you know and as you’ve seen in your practice, they can go out and they can access additional credit secured by that housing equity.

So they can go, they can refinance the mortgage, they can take out some money to — pay their bills; they can get a second mortgage or a third mortgage, and they can sort of kick the can down the road, and hopefully they find employment and house prices keep rising, it’s not an issue, okay.

But if you instead look at a situation where house prices stopped rising or, God forbid, they fall, that same borrower, when they run into problems, they don’t have options. And so that’s when you see the arrears rate start to really rise.

And we saw this in the US as well: if you look back at 2005, 2006, that’s when house prices started to flat line across the country in the US, and it really wasn’t until a year later when some of those riskiest borrowers could no longer refinance, when all of those exotic mortgages, like those adjustable rate mortgages, when they reset and those borrowers were not able refinance in conventional financing, that’s when you saw the arrears rate really spike.

And so my idea has always been that the arrears rate is a lagging indicator and it’s going to be a function of house prices. So that’s why, you know, I’ve got this view that if house prices just flat line in Ontario, and if they go flat for a year or two – it doesn’t happen right away, but if they go flat for a year or two, but the economy doesn’t deteriorate – if all that happens is house prices just go flat, you’d probably see a doubling in the arrears rate.

Now there’s an artificially low right now, if you look at it in Ontario, and that’s not the exact numbers, but it was something like fifteen basis points in arrears, so it’s 0.15% of the population is in arrears on their mortgage. That is unbelievably low by historical standards.

Doug Hoyes: Yeah, it’s essentially nobody.

Ben Rabidioux: The economy is not, you know, in sync. Yeah, nobody – nobody – so that goes to my point, you know, how can you default on a mortgage in this market when the prices are rising so quickly? You have so many options at your disposal. That changes dramatically when you see softness in the real estate market.

Doug Hoyes: And so is there anything that you can see that would cause prices to stop rising? I mean obviously mathematically, house prices cannot go up forever; it means a one-bedroom condo in Toronto will eventually be worth $100 million. I mean, in the absence of hyperinflation, that just doesn’t make any sense.

But is there anything else that could potentially cause a levelling off of house prices? Really just the general economy, or is there – could it be something else?

Ben Rabidioux: There are a number of factors that I think are at work in the housing market. I think there is – it’s topic of some contention right now, but in my view, having done extensive deals in some of the frontlines, there is a sizable foreign bid in both Toronto and Vancouver, particularly in Vancouver, but also in Toronto.

And you know, we don’t really understand the mechanics of the dynamics behind that, but it seems that there is definitely somehow – and the fact is that it is somewhat about capital preservation bid out of China in particular.

Doug Hoyes: So you’re talking about Chinese investors, or people from outside of Canada buying real estate in Canada, perhaps because they need to get the money out of China, and that is helping support the real estate prices. Do you have any sense of how significant that is in a place like Toronto for example, or is it impossible to know for sure?

Ben Rabidioux: Well, it’s impossible to know for sure. We don’t have hard data on this. The government is looking to collect hard data, so CMHC in particular is trying to figure out how to better track this.

Well, my sense is this – and again, this is just – this is nothing more than just trying to triangulate anecdotes, so this is not scientific in any way, and you know, there is a saying that the plural of anecdote is not data, so this is not hard data by any means.

But my best guesstimate is, we probably are seeing somewhere between five to ten percent of resale transactions in Toronto are foreign debts. And that’s obviously much higher in certain property segments and certain locations, but I think across all of Toronto it’s probably something like five to ten percent. I’d be surprised if it’s significantly higher than that. I think in Vancouver it could be 15 to 20%. Again, this is just complete throwing a dart, my best guess, having spoken to extensive, you know, people on the frontlines.

But I think what you have to keep in mind is, so that’s the percentage of resale transactions, but when you look at the property types that are often being purchased, they tend to be much higher price points, particularly in Vancouver they tend to be kind of the ultra-luxury – you know, West Side Vancouver, single family, etcetera.

And so if you look at it instead as a percentage of the dollar volume of sales, it could be three times that. So you could be talking 15 to 30% of the resale dollar volume in Toronto as foreign – that’s a huge number.

And then there’s also the trickle-down effect, so the family that’s bought a home – a detached house in central Toronto forty years ago for some obscenely low price by today’s standard, is an instant millionaire and so they then often, as the anecdotes go, they would sell their house, they would gift some money to all of their adult children, who then in turn use that money to jump into the real estate market. Mom and Pop sort of downsize and move out of central Toronto.

And so you can see how that trickle-down effect has had an impact on the rest of the market, so that’s a real dynamic.

There’s some question around the sustainability of that dynamic in its entirety. I think there’s always going to be a foreign bid; Canada certainly is an attractive place. But I think the magnitude of the current bid is probably unsustainable, but that said, like I don’t think – and I don’t know exactly when that changes. We could see tomorrow that Beijing tightens capital controls and the bid drops by 50% overnight – it could happen, right.

So we don’t know, but my feeling is that this is not a permanent sustainable bid in its current size; that there’s a subcomponent of this that is speculative. It is a hot money bid and one thing you can be certain is that hot money that flows into an asset class will always flow back out – always – at some point.

So again, not the entirety, right; there’s some of this foreign bid that’s a legitimate – you know, we want to live here, we want to send our kids here, it’s a sticky bid – but there’s a speculative bid as well and that’s somewhat more of a concern. So that’s one dynamic that, you know, when we think about what could tip the market. And then certainly the broader economy.

If we saw a broad slowdown, I think the most likely area where we would see a broad slowdown, at least in Ontario, would be more in the construction industry. You know, I’m still of the view that when you’re looking on underlying demographics, it’s difficult to make an argument that we’re building at a sustainable level. And so if housing starts to fall significantly and the level of construction and housing renovation were to fall, then you’ve got a big hit to the economy and the labour market. So that’s one area; you could get some sort of exogenous shock that the US goes into recession or who knows what.

And then I think the third obvious one is interest rates. I’ve said that I don’t really think that’s going to be the trigger, but look, if the Bank of Canada moved, or perhaps more importantly, if the Federal Reserve and the rest were to hike up their twenty five or fifty basis points, that affects our bond market, and our five year fixed mortgages tend to be priced off of the five year bond yield.

And so even if the Bank of Canada doesn’t move, we could find that fixed mortgage rates in Canada start to creep up. And there’s not really a lot of wiggle room on affordability there, so it could certainly pinch affordability and, you know, cause some sort of a reduction in demand.

Doug Hoyes: So there are lots of potential factors. That’s very good. We’re going to take a quick break and then we’ll come back with a bit more with Ben Rabidoux. You’re listening to Debt Free in 30.

[Music]

It’s time for the Let’s Get Started segment here on Debt Free in 30. My guest today is Ben Rabidoux and we’re talking about real estate. So Ben, in this segment I’d like to talk about some practical advice.

So what advice would you give to someone who is either in the real estate market today, or is thinking about getting into it? What are some things they should be practically thinking about?

Ben Rabidioux: Sure. And first maybe I can preface that by saying that every person’s situation obviously is unique and not having any insight into the specific situation of some of the listeners, it’s difficult to give blanket advice.

So you know, what I would say is, if you’re a young person and you’re fairly new in the job market and you’re debating whether to buy or rent a condo in particular – I’m going to use the word specifically with the segment of condos – I think today is a great time to be renting, because when you start to look at the all-in ownership costs versus the rental cost, it’s very difficult to make the argument that it makes sense financially to own at this point. And so that’s specifically the young people looking specifically at condos.

Now, I think it gets a lot more nuanced when you start talking about families with kids and you start talking about single family homes, because there’s frankly a lack of good single family rentals. And that’s a market that is quite unique, particularly in places like Toronto, in that there are some legitimate supply constraints that are sort of keeping a lot of new inventory off the market.

So there I think it’s not an easy discussion; you really have to look at how much can you comfortably afford, look at – you know, I certainly wouldn’t be buying a 5% down in this market; I would certainly wait till you’d saved, you know, ten, fifteen, twenty percent ideally.

And then also, I would just say that, you know, avoid this whole fear of missing out. We’re hearing this a lot in the media that people are really rushing to buy in because they’re fearful of being priced out of the market forever. That sort of mentality typically leads to very bad decisions, and it’s also highly indicative of some late cycle type mentality. That’s usually not the sort of mentality that you see in a normal, healthy market.

And so just be mindful of that; if you’re rushing out to buy simply because you’re fearful that you’re going to priced out of the market, it’s probably not a good decision. So keep that in mind.

And then the other thing I would just say is, be mindful of the industry you’re employed at. As I mentioned earlier, we do have a record percentage of employment in construction, finance insurance and real estate industries. These are industries that are cyclical, but that haven’t seen a real cycle in twenty years.

And so if you are employed in the construction industry – particularly if you’re employed in residential construction – recognise that this is the best of times and you are in a cyclical industry, it’s not always going to be this good, and budget accordingly. Make sure that you’re taking this opportunity with the market boom in the way it is to aggressively pay down your debts and to prepare for the reality that there is going to be another cycle in this space, and you want to be prepared for that.

Doug Hoyes: So you mentioned aggressively paying down your debts; what thoughts do you have on the whole debt area then? Obviously lower debt is better, I guess, or is this the time to be leveraged up to the hilt?

Ben Rabidioux: Well, that’s the big question. Look, if rates stay this low forever, then it’s probably great time to be taking on debt. But the reality is, we don’t know, and the reality is that rates are at unprecedented lows, and they are likely to be moving higher over the longer term. It’s probably a great time to be paying off your debt, particularly high interest debt – it is a great time to be paying that off.

And look, I know that we’re in an environment right now and in an economy where a lot of people are taking on consumer debt to finance consumption type goods; to finance toys and to finance trips, etcetera. That’s a pretty bad idea, so if you’re going to be taking on debt, you know, as much as you can, make sure it’s being put to use in a productive manner, so either purchasing assets or education, etcetera. Do your best to avoid that consumer debt, because it is a real temptation with rates this low, but just recognise that rates won’t always be this low and the economy won’t always be this – so this is a great time to be aggressively paying those down.

Doug Hoyes: And I can’t disagree with that. So I guess the final comment and maybe the final thing to leave people with is, everything moves in cycles and just because the real estate market has been up for ten straight years in Toronto, doesn’t mean it will be up straight for the next ten years. You’ve got to be mindful of the fact that we’re potentially nearing the end of that cycle, maybe not tomorrow – I mean, we’re recording this in June of 2016, so if people are listening to it in the future, things may have already changed.

But that’s a key point, I guess – recognise where we are; things are pretty toppy and so being aggressive now is probably not a good idea.

Ben Rabidioux: Couldn’t agree more.

Doug Hoyes: Great. Thanks, Ben. So the practical advice is if you’re a young, single person looking for a condo in Toronto, now is a great time to rent. What you’ll pay per month in rent is less than you’ll pay in mortgage payments, property taxes, condo fees and repairs and maintenance. So unless you think the real estate market will continue to increase for the next few years, it’s an easy decision.

It’s a bit more tricky if you have two kids, a dog and a cat, because rental accommodation for families is a bit harder to find, so that’s when you have to crunch the numbers to make sure you aren’t taking on more debt than you can afford.

Ben, thanks for being with me today. I really appreciate it.

Ben Rabidioux: My pleasure. Thanks, Doug.

Doug Hoyes: Thanks, Ben. That was the Let’s Get Started segment. I’ll be back to wrap it up right here on Debt Free in 30.

Doug Hoyes: Welcome back. It’s time for the thirty second recap of what we discussed today. My guest today was Ben Rabidoux, who described some areas of concern in the Canadian real estate market. He said that real estate is cyclical and just as prices corrected back in the late 1980s and early 1990s, it could happen again.

That’s the thirty second recap of what we discussed today.

I agree with Ben’s point about FOMO – the Fear Of Missing Out. Many people today see that interest rates are low, and since it seems that real estate keeps going up in value forever, they want to get in now, because they don’t want to miss out on future gains.

Well, it’s mathematically impossible for prices to go up forever, so be very careful not to borrow more on a mortgage than you can pay back. It’s no fun being house-rich, but not having any cash left over to live your life. Ask yourself the question, if I was to lose my job, or if my income was to go down, could I still pay the mortgage, the property taxes, the repairs and maintenance and my condo fees?

If the answer is no, you’re probably stretched too thin and as Ben said, for many people, now is a great time to rent.

Helping Adult Children Financially Can Lead to Insolvency

Rebecca Martyn

Posted in Dealing with Debt

Reading time: 4 minutes

Hoyes, Michalos & Associates Inc. - Hoyes, Michalos & Associates Inc. | Ontario Licensed Insolvency Trustees
Young girl with life jacket on to show financial support can lead to insolvency

This is a tale I am hearing far too often: “I was helping family financially and now I can’t afford my own bills”.

Between the high cost of housing, student loans and the lack of quality full time jobs, Canadians in their 20’s and 30’s are stretched to the limit and their parents, and sometimes grandparents, are stepping in. The problem is, for many this leads to an increased risk of their own insolvency.

Consider the story of one couple we helped, Frank and Susan (not their real names), also known as mom and dad.

Frank and Susan are both retired and in their late 60’s with decent pensions. However, years of supporting their daughter and her family lead to financial strain. A decent pension for a family of two is hard to stretch to helping a family of five.

Here were the issues:

  • Frank and Susan used their good credit to borrow money to loan funds to their daughter & son-in-law (Karen & Bill) for a down payment to be able to buy a home. 
  • They were also providing day care. This meant higher costs making the drive to pick up the kids at home, at school and take them to after school activities. Meanwhile, Karen and Bill were not giving mom and dad any gas money, or paying for day care.
  • Karen & Bill asked their parents to help finance emergency repair costs on their furnace.  That led to more borrowing for Frank & Susan since they didn’t have the cash on hand.
  • And when Karen and Bill were stretched financially from too much debt and overspending, mom and dad found themselves buying groceries to help out.

Before they knew it Frank and Susan had over $50,000 in credit cards and loans.

This is not an unusual scenario. There are many ways parents find themselves spending money supporting their adult children for too long:

  1. Parents are increasingly postponing retirement and taking on debt to help pay for their children’s education.
  2. Parents and grandparents are helping younger adults get a foothold in an expensive housing market or buy a car by cosigning or loaning them money for a down payment.
  3. Many become an alternative to payday loans, loaning money between paycheques or paying for the day-to-day living expenses of a second household.

We’ve even seen siblings helping out siblings financially when neither could really afford it. There is a risk however to both families for this kind of help.

Now older, and many retired, these same parents no longer have the time or income themselves to recover. They are much more susceptible to misfortune due to illness, disability, even the death of one spouse. While they may not care that their credit report will suffer, they do become burdened with debt themselves when their children default and stop making the payments.

What’s more, the adult children become deluded as to how much they can afford to buy. The bank of mom and dad doesn’t use the same credit capacity rules as a traditional lender. Often they find no need to balance their own personal budgets, when mom and dad will help out.

In the end we helped both families deal with their debt.

Frank & Susan filed a consumer proposal (owning their own home, and with both having a good pension the cost of filing bankruptcy was too high) while Karen & Bill, with 3 dependents, found bankruptcy to be the better solution.

What’s the moral of this cautionary tale?

Helping out family is fine, but only if you can afford it. Don’t risk your financial security in order to make life easier for your children or grandchildren.

If you are facing debt under these same circumstances, sit down with your family and talk it through. You may have to tell your children you can no longer provide them with financial support. Consider if you both need to speak with a debt expert about how to resolve your situation.

Self Employed: Dealing with Business Debts

J. Douglas Hoyes

Posted in Dealing with Debt

Reading time: 36 minutes

Hoyes, Michalos & Associates Inc. - Hoyes, Michalos & Associates Inc. | Ontario Licensed Insolvency Trustees
Self-employed woman standing by her business

As our economy in Canada has evolved so has the nature of most people’s employment. Downsizing and outsourcing has become more prevalent, stable jobs have become more scarce, and more people are becoming self employed. While the freedom and potential for success are great, being self-employed brings its own challenges when it comes to managing business debts.

On this week’s podcast I talk with Ian Martin, Scott Schaefer and Ted Michalos about the potential debt problems that entrepreneurs and self-employed persons might face and provide tips that can help you avoid these common small business mistakes when it comes to managing your finances.

I also talk with our experts about how to deal with one of the most common business debts: tax debts owing to Canada Revenue Agency.

Financial Tips For Avoiding Small Business Debts

Ian offers these tips to help you avoid mounting business debts when launching your new small business:

  1. Have some savings set aside for start-up & living costs. Not having sufficient funds to cover the start-up phase can cause the self employed person to accumulate debt before they are able to start making a profit. Have enough saved up to cover both start-up costs and personal living expenses until the business is generating enough cash flow to provide you a salary.
  2. Have a good cash flow projection.  Make sure you have a comprehensive business plan including how you will deal with keeping up with all your payments.
  3. Arrange for low cost financing up front. Avoid relying on personal credit cards while running a business as this can lead to personal financial problems as well as increasing business risks.
  4. Pay your taxes. Put enough money aside throughout the year to cover income taxes, HST, and CPP contributions. Some self employed people may not be aware that they have different tax obligations or may use tax money collected for their living expenses hoping things will improve and they will catch up later which can cause problems and lead to significant tax debts.

Self Employed & Tax Debts – What Should You Do?

It’s not uncommon for a self-employed person to find themselves owing money to the CRA. When you are employed, your employer withholds income tax and other tax obligations from your pay and remits them to the government for you. As a self-employed person you have to make installment payments. You may also be collecting HST throughout the year which must be remitted. It is dangerous to use that money to fund your business or personal expenses as you will find yourself owing significant money to Canada Revenue at the end of the year.

To help small business owners and self employed professionals, Scott offers these tips to keep tax debts under control:

  1. Is the business viable? Does it generate enough revenue to cover business expenses, taxes, and your living costs? Look at monthly statements. See how much you are actually bring in. Is the business making money month over month? How much do you need to live on? How much to you need to deal with outstanding debts.
  2. What taxes are owed? Have you remitted your HST? Have you made both the employee and employer contributions into CPP? Have you paid your income tax? File all your returns and figure out how much you owe as a starting point.
  3. Start treating yourself like an employee. When you were an employee your employer took taxes off your pay. Do the same. Pay your HST every month. Pay an installment towards your taxes as if you’re an employee. 
  4. Consider hiring an accountant or a book-keeper. They will help make sure you keep on top of your payments. A good accountant can ensure you priced your jobs right or create a financial plan to adjust to problems much quicker.
  5. Speak with the right professionals before deciding to do something like incorporate your business. Depending on your situation, it may or may not make a lot of sense. Be sure to do your homework and ask the right questions.

What do you if you owe taxes for multiple years?

If you are self employed and owe taxes, make a plan to deal with back debts.

Deal with your tax debt as soon as possible to stop further interest & penalties. If you have the money in the bank, pay CRA. You can usually negotiate a repayment plan with the CRA to pay off back taxes if you can do so in 12-24 months.

If you can’t afford repayment of back taxes, consider a formal procedure like a consumer proposal.  A Licensed Insolvency Trustee is the only professional able to make a settlement offer with the CRA for less than the full amount of your tax debt.

Resources mentioned in the show

FULL TRANSCRIPT show #93 with Ian Martin and Scott Schaefer

self employed with taxes and other debts - fb

Doug Hoyes: Here on Debt Free in 30 we focus on how as a person you can become debt free. But what happens if you’re self-employed or you own a business and you have debt problems? Is having business debt different than having personal debts? It’s an important question because an increasingly number of people today are self-employed. Many years ago you got a job at the factory or in an office and you worked there your entire life. Today with all of the downsizing and outsourcing secure jobs are hard to find so many people become self-employed.

For some people being self-employed or owning your own business is great. You set your own hours, you don’t have a boss and if you’re successful you can make a lot of money. It’s great. But of course there are also disadvantages. Being your own boss really means being your own company. You’re not just the guy doing the work, you’re also the guy doing the book keeping and paying the bills and fixing the computer when it doesn’t work. You’re responsible for everything, good and bad. Some people like that. Others prefer to just do what they’re good at and nothing else.

There are many occupations where being self-employed is very common. Many truck drivers for example are self-employed. They aren’t employees of the trucking company, they actually own their own truck or tractor as it’s called in the business and they get paid by the kilometre. They can make good money but if they don’t work, they don’t get paid. If the truck needs repairs, they need to pay for it. So, there are advantages and disadvantages when you’re self-employed. Construction is another industry where I see lots of people who are self-employed: roofers, drywallers, frames, plumbers, electricians, they’re all often self-employed. So, what problems can it cause if you’re self-employed?

To find out I’ve asked Ian Martin to come join me. Ian is a chartered accountant, a CPA and a licensed insolvency trustee in the Hoyes Michalos Kitchener and Stratford office. Ian, welcome. As I said in the opening being self-employed has many advantages but there are also some drawbacks and one of those problems is that you’re responsible for all the money management, the finance, the bookkeeping. So, you’ve helped lots of people over the years, what problems do you see self-employed people or people who own their own business getting into?

Ian Martin: Well, I mean you can go a lot of different ways in answering that Doug. And I feel like your intro there kind of hit on kind of the highs and the lows. It’s easy to focus on the success stories that we’ve heard over the years. We can think of examples, my great uncle came to this country and he didn’t know very much, and he built his business with his own hands and now he owns his own house and he’s a true Canadian success story.

However, the opposite at the end of the spectrum is more often the case, meaning that it’s not successful. So, I think the biggest challenge if you compare to someone who’s an employee is with a regular pay cheque is that when you’re the ‘man’, when it’s your business is having the regular sustainable cash flow so you can manage all the other aspects of your life.

You said already that when it’s your business when you’re the ‘guy’, it’s not just raising the business and finding the clients it’s doing that, it’s doing the work, it’s paying the bills, making sure you’ve set aside all the money for all your different tax obligations, take care of the bookkeeping or finding the appropriate people to help you with those things. So, it’s not just an idea, it’s having an idea and also a comprehensive business plan to get through it. But then also having the financial backing to kind of whether the storm of kind of the ups and downs.

Doug Hoyes: So, let’s talk about that. Financial backing, so what do you mean by that? You’re saying that when I start a business it’s not like when I get a job, I don’t have to have any cash in my pocket when I start a job ’cause I’m going to get my first pay cheque in two weeks.

Ian Martin: Right, exactly. So, there’s lots of businesses where, when you’re starting the business there’s what we call the start up costs. Where, one of the examples that you gave was the truck driver, what we call the owner operator. Well, that means you own a truck. And it’s not like buying your Ford F150 where it might be 30, 40, $50,000, we’re talking about trucks. It can be hundreds of thousands of dollars. So, with that you’re either having the capital to pay for that or having like a huge, huge monthly payment that can be several thousands of dollars. Well then you need to be bringing in enough money to cover those costs.

Doug Hoyes: Yeah so even if I’m able to go out and finance a brand new truck and even if my monthly payment is going to be, I don’t know, $10,000 a month on the truck, I’ve also got to pay insurance, I got to put fuel in it and whatever other costs I’ve got associated with that. And I don’t get my first pay cheque the first day.

Ian Martin: Right. And what I find, I mean it’s probably part of the work that we do in helping people who are insolvent is that a lot of people, they go into business for themselves when other things haven’t worked out. I met with a guy just last week and, you know, nice guy, very articulate, very well educated but within his industry over the last 15 years he’s been the casualty of four or five different layoffs over the span of the last 15 years. And has become very I’ll say skeptical or cynical in the big corporation and working for the ‘man’.

So, understandably he’s decided he wants to be his own boss and we had a good conversation last week and he has opportunities to be an employee for somebody else and have a decent paying job. But he said to himself I need to give myself enough time to see if I can do this on my own. So, he’s given himself six months. He has some contracts, he is – to be true to himself he wants to make sure that he can make it good a business for himself. And if it proves at the end of the time period that he can’t, he’s got to fall back.

But I guess the point I was trying to make there was so many people they find themselves where they’ve been a casualty, where they’ve lost their job and then there might already be some debt problems. And then they go into business for themselves. So, instead of having saved up, you know, $10,000 or $20,000 or $30,000 to cover the expenses in the start up phase, they’re relying on credit or basically debt to get them through the start up phase.

Doug Hoyes: And you think about this particular guy so and we’re not going to talk about what kind of business he’s in or anything because that’s not necessary. But the first month he starts his own business he’s out there looking for clients, he maybe finds some clients, he’s probably not getting paid anything the first month. Maybe not the second or the third month but he’s still got to pay his own rent, still got to buy his own groceries. So, he’s still got to have 2, 3, $4,000 coming in every month just to pay his living expenses.

Ian Martin: Right, well that’s the key. We talk about business expenses but this specific person I’m referring to, he’s married, he has a couple of kids at home. So, it’s not only having enough money to cover your business expenses but then also it’s replacing the pay cheque to cover your personal, your living expenses as well and that can be a tremendous challenge if you don’t have the money saved up to get over the hump of the first however many months to have the regular contracts, the regular cash flow come in.

Doug Hoyes: Yeah. And most people aren’t super rich when they start their own business otherwise why would they bother? You’re right, they either have no money or they’re already in debt and they’re just trying to get back on track.

So, from a cash flow point or view then what you’re saying the number one problem you see that people run into when they’re starting a business or when they’re self-employed is not having enough cash in their pocket when they start and there’s two things you got to consider, your own personal expenses, which don’t go away, your rent, your groceries, whatever and then whatever it’s going to cost you to operate the business. So, if you’re going to be a truck driver and you’re not going to get your first pay cheque for six weeks, can you put fuel in the truck, can you pay the lease payments for those first six weeks? If you can’t it’s going to be a serious problem.

Ian Martin: Right exactly. And from the work that you and I have done, Doug, I mean we see people that, the ideal situation like we said is that you saved up the money, you have the cash flow projection, you’ve got your comprehensive business plan. And you know you have the savings to get over that hump of the first however many weeks or months. But if you don’t, it’s human nature that you rely on credit to get over that start up phase.

Doug Hoyes: Final question I want to ask you before we take a break is taxes. So, you in a past life worked for a big government agency that collects taxes, we won’t mention their name.

Ian Martin: You might guess what it is though.

Doug Hoyes: Their initials are CR and A. So, I start my business and it’s not like being an employee where the taxes are coming off my pay cheque every week. No taxes are coming off. I’m getting a cheque and then at the end of the year I file my taxes and if I’ve been successful I now owe money but I haven’t put any money away and now I’m really in trouble. Is that something you see quite commonly?

Ian Martin: Well, you set me up there. You know the answer is yes, Doug. And I feel like when people – with the tax end of the challenge that we’re talking about here it’s really twofold. Number one, I see a lot of people who get into being self-employed who don’t truly understand their different obligations to be setting aside the money for their tax installments or their HST account. So, sometimes it is a lack of knowledge.

But then also secondarily even if there is that knowledge and understanding just as we were saying earlier you’re getting through that start up phase and the cash flow is tight, even if you know that you should be setting aside the money for those different obligations for next year, you just can’t. You still have to pay for the rent or the mortgage, got to feed your kids and your family. You know it’s not the right thing but you take the government’s money and you’re paying for those other things. So, when you’re paying your taxes the following year it’s just not there. Maybe the first year it’s not so bad and, you know, the business is getting a little bit stronger and you feel like you can build up and catch up but if that snowballs for two or three years, that can be a pretty big mountain to overcome.

Doug Hoyes: Yeah and the government doesn’t just wait around, that’s the –

Ian Martin: Well, that’s the tricky part with them. They will kind of be asleep for maybe a couple of years. But by the time they do wake up then you’re behind on your taxes and your HST by two or three years, by that point unless the business is really, really grown and matured it can be tough to overcome that.

Doug Hoyes: Yeah and they’ve got lots of power to do lots of things. So, excellent. Well, I appreciate that. We’re going to talk about more in the second segment about taxes and some other factors that affect self-employed people. I’m going to bring your partner Scott Schaffer to talk about that. Ian, thanks very much for being here.

Ian Martin: Thanks very much Doug.

Doug Hoyes: Thank you. We’re going to take a break and we’ll be right back talking about issues that affect self-employed people and small business owners right here on Debt Free in 30.

Doug Hoyes: In the first segment we talked about how a self-employed person can get into financial trouble. The common scenario is that you start working as a self-employed person and you’re making good money. And then at the end of the year you realize you haven’t made any tax payments and now you owe the government a bunch of money. When you’re an employee working for someone else, taxes get taken off your pay cheque every week so at the end of the year when you file your taxes you’ve probably paid enough and may even get a refund.

But if you’re self-employed and you’re responsible for paying your own taxes and that’s where you can get into trouble. So, what happens if you haven’t paid your taxes? What are your options? To find out I’m joined by Scott Schaefer who is also a chartered accountant, a CPA, and a licensed insolvency trustee working with Ian Martin in our Kitchener and Stratford offices.

So, Scott when you meet with someone for the first time and you know potentially in the future taxes are going to be a problem, what’s your starting point with them? What’s the first thing you discuss to make sure that that’s not going to be an issue?

Scott Schaefer: Yeah so we first sit down and we look at is the business viable? So, we don’t think too much of the past right away, we look at the business as it is today. Is the business making money? Is it viable? If it wasn’t for the tax debts or the debts that you’re carrying at this point, could this business be a very profitable, a very viable business?

Doug Hoyes:  So, by viable you mean in simple terms is more cash coming in every month than going out?

Scott S:: Yeah, are you making money?

Doug Hoyes:  Are you making money, that’s really the question. And that seems like an obvious question, are you making money? Well, if I’m not making money wouldn’t I know it? Why would that be an issue?

Scott Schaefer: Well, if somebody hasn’t filed their taxes, if they haven’t put a reserve for it and they don’t have the money for that then they may not have been making money. They had enough cash flow to come in to pay for their own expenses but the business hasn’t actually been making enough money to pay for the taxes, the HST, the suppliers things like that. There’s accumulation of debt that may not be known at this point.

Doug Hoyes:  So, if I’m a self-employed guy or girl and I’m, I don’t know, I’m doing some let’s say it’s a service kind of business, maybe I’m in construction, maybe I’m a massage therapist, whatever. And over the course of the year I’ve brought in $40,000 after paying my expenses, so, after paying my rent and everything. What kind of tax obligation am I going to have? I mean am I – is that like 10%, 20%, 50%.

Scott Schaefer: It’s not much higher. You’ll have the HST so if you haven’t remitted your HST that you’ve been collecting along the line because if you have sales of more than $30,000 you have to have an HST account, so have you set aside the HST?

Doug Hoyes:  And that’s 13% of your revenue in Ontario.

Scott Schaefer: Correct.

Doug Hoyes:  Different numbers in different provinces.

Scott Schaefer: And you’ll get some deductions for the input tax credits but 13% think of that as a starting point. Then you’re looking at your personal taxes. You would be paying both the CPP for the employee and the employer portion, which that’s you, you’re both sides. You’re the employee plus employer.

Doug Hoyes:  And that’s a big difference from being an employee, because when I’m an employee they’re only taking off –

Scott Schaefer: Your portion.

Doug Hoyes:  Effectively half as much as what the total is.

Scott Schaefer: Correct.

Doug Hoyes:  Okay, so, I’ve got HST that I maybe wasn’t thinking about. I’ve got CPP that I’m responsible for.

Scott Schaefer: And those tax rates about 20, 21%. So, the first $10,000 being tax free so you’re going to be paying at least 20% on the $30,000. So, if you made 40, $10,000 tax free you’d be paying, so you’re at least $6,000 tax debt, plus the CPP and HST.

Doug Hoyes:  And we’re talking obviously very rough numbers here because everyone’s situation is going to be different. You might be in a higher tax bracket than what we’re talking about. But let’s assume your number of $6,000.

Scott Schaefer: And that was barebones so chances are it’s going to be much higher.

Doug Hoyes:  That’s very basic. It’s probably higher. And that’s ignoring HST and the CPP and everything. So, at the end of the year you file your taxes, now you own $6,000. Do you have $6,000?

Scott Schaefer: Right. Will the business allow you to make enough money to pay the current taxes plus this past tax debt.

Doug Hoyes:  And $6,000 means I should have been putting aside $500 a month. Am I doing the math right there?

Scott Schaefer: Yeah.

Doug Hoyes:  So back to your comment about viability then.

Scott Schaefer: Right. Is the business making enough to put $500 away for the current taxes plus pay towards last year’s taxes? And quite often for self-employed it’s a two or three year lag where they’re kind of playing catch up. New business, new experiences, they kind of get behind the eight ball, it happens, you’re out there pounding the pavement to get, you know, revenue in to make money to pay the bills. You may not be on top of your taxes or be so overwhelmed and afraid of that number to file it, it may be a lot bigger than you think it is.

Doug Hoyes:  Yeah and often in the first year you’re not making any money anyways. So, it’s not the first year where you get the huge tax hit, it may be the second year. So, what’s your advice then to someone? Is it as simple as well make sure you’re putting money aside?

Scott Schaefer: First thing I’d like to look at is let’s do a monthly statement? How much are you making per month? Are you actually making money each month? So, we sit down, once again, not looking at the past, looking at the future saying is this business making money month over month? And if so, how much do you need to start putting away? How much do you need to live on? Now do you have money left over to deal with the past debts?

If the answer’s no first know that you can stay current going forward so you have to treat yourself like an employee, so you’ll pay your HST every month, you’ll pay an installment towards your taxes as if you’re an employee and it goes right away. And then we figure out a plan to deal with the past debt. Because it so big that you won’t be able to stay current and deal with the future plus the past.

Doug Hoyes:  Are you a big believer in a self-employed person hiring a bookkeeper or an accountant or someone like that to help you with that part of the business?

Scott Schaefer: Absolutely. For me as an accountant, I would never do any electrical or plumbing on my house. I will always hire the proper service to do that. I think if you are brilliant at your trade, hire an accountant or bookkeeper to keep you current.

Doug Hoyes:  And just so you don’t think we’re tooting our own horn here, you and I are both CPAs, chartered accountants, but we don’t do books for people.

Scott Schaefer: No.

Doug Hoyes:  That’s not the business we’re in. So, we’re not saying come to us and we’ll be your bookkeeper, we’re not the experts in that.

Scott Schaefer: There are people who are brilliant at bookkeeping. The thing about accounting is, it’s always historic data, it’s after the fact. I like it if you have a bookkeeper you can drop off your box of envelopes and slips each month and they just kind of summarize it. You always know whether your priced your jobs right, you always know whether you’re making money, you know you can adjust to things much quicker.

Doug Hoyes:  And it’s money well spent.

Scott Schaefer: Absolutely.

Doug Hoyes:  And should I be incorporating if I’m going to be a business, first of all what does that mean?

Scott Schaefer: Incorporation is just a legal entity so you incorporate a business. My general suggestion is that if it’s a personal trade business so you are just a massage therapist, incorporating a business is just another layer so you’re now running through corporation, you know have to do corporate tax returns, everything’s running through that. You’ve added a lot more accounting fees. You’ve got lawyer’s fees and you got accounting fees. So the business is not making a lot of money or there’s no good business reason to do so, I generally don’t recommend incorporating.

If it is because you’re building widgets and you’re buying machinery, you’re building all these other things, an incorporation could be a very logical decision at that point because there’s a lot more strategies involved. The cost to incorporate through lawyers and accountants and doing corporate returns makes more sense because the business is making a lot more money, there’s a lot more reason to do so.

Doug Hoyes:  Yeah. If you’ve got 15 or 20 employees, if the business has been around for a few years and it’s making good money then being incorporated makes sense, if you’re just starting out, probably not. And you’re right, you’ve got to pay a lawyer to incorporate the business. You don’t have to, I guess you could do that yourself but I don’t do my own dental surgery so you’re looking at paying someone up front to incorporate, that’s a onetime charge.

But then you’re right, every year you’re doing corporate tax returns and I mean I personally obviously am one of the owners of Hoyes Michalos & Associates Inc., which as you know is a corporation ’cause it’s got the word Inc. at the end of it. I don’t do our corporate tax returns; I hire someone to do that. There’s a cost for that every year.

Scott Schaefer: And a lot of people think that the corporation will prevent them from having personal liability. Some parts are true but really you’re the director of the corporation, you’re responsible for HST, you’re responsible for sourced deductions. If you don’t pay those, those debts will follow you personally. The government has a right to jump through the corporation to come after you for that. Most times the banks going to make you sign a personal guarantee anyways, so, the corporation is just another layer.

So, there’s times it makes a lot of sense and there’s times that don’t, that it doesn’t make sense. The key is to make those decisions off the bat, do you homework, think about it, ask the right questions, talk to an accountant, talk to a lawyer, figure out for yourself right at the get go if that makes sense.

Doug Hoyes:  Yeah so in the first segment Ian and I talked about having adequate financing or cash flow to start your business. So yeah it is a good idea when you’re starting out to have $1,000 or whatever it’s going to take to get the lawyer to do his thing. Have some money to be paying the bookkeeper up front as well as obviously paying all your business expenses up front.

Scott Schaefer: I generally think the more the business will make, the more a corporation makes sense. Because you can afford those costs and there’s more strategies to avoid, to avoid certain things, to deal with it differently, to do different tax strategies, to do it differently. All legally, there’s things you can do for that stuff, it’s just a different strategy. But it has to be bigger numbers to actually have any bang for the buck. If it’s going to be a business making $50,000 there’s not a lot of bang for your buck. If it’s making millions of dollars, absolutely there’s some great strategies there.

Doug Hoyes:  So start off as a self-employed sole proprietor as it were. So, your advice then as we wrap up this segment is when you’re starting out you want to set the ground work, get everything set up correctly if possible.

Scott Schaefer: Absolutely.

Doug Hoyes:  And be thinking ahead that’s really what you’re saying.

Scott Schaefer: Absolutely.

Doug Hoyes:  That’s why you’re saying do a budget or whatever try to figure out for example what your tax obligations are going to be next year so that you’re able to set aside the money or actually send it to Revenue Canada as you go.

Scott Schaefer: Absolutely. Worst case is you get a refund, which isn’t a bad thing.

Doug Hoyes:  And there’s nothing wrong with that. Excellent well I appreciate that Scott. Some advice on how to be self-employed and how to avoid some of the problems that come up. We’re going to take a break and in the final segment I’m going to ask Ted Michalos to come in here and give us some advice on what to do specifically if you already have a lot of debt, hopefully with the advice we talked about that won’t be an issue but if it is we will talk about that. Thanks very much Scott, you’re listening to Debt Free in 30.

It’s time for the Let’s Get Started segment on Debt Free in 30 and today we’re talking about business issues. What kind of trouble can you get into if you’re self-employed and how do you avoid it? In the first two segments I talked to Ian Martin and Scott Schaefer and one of the issues they raised was that as a self-employed person sometimes, well it’s easy to get behind on your taxes. The first year you’re not making much money, you’re used to be an employee and having the taxes come off every pay cheque. And now all of a sudden, uh oh, it’s time to file my taxes, I haven’t put anything aside and now I’ve got a bunch of tax debts. What can you do if you’re in that situation?

So, the Let’s Get Started segment is where we give some practical advice so I’ve asked Ted Michalos to join me for this segment. So Ted first question have you ever dealt with people are self-employed who get into trouble with taxes and all sorts of other debts?

Ted M:  You mean today or at any time in the past?

Doug Hoyes:  So, this is not an uncommon scenario at all.

Ted M:  Three text messages on the weekend from people that unfortunately I gave my cell phone number to on this very subject.

Doug Hoyes:  So, there you go. So, this is a very common thing and it’s I assume as I described it you just don’t get around to setting the money aside and now you’re into a bigger situation.

Ted M:  That’s right. The tax man isn’t on your shoulder every month saying you got to pay this bill, you got to pay this bill. So, they’re usually the last people to get paid.

Doug Hoyes:  Okay. So, what do I do then? It’s now been a year or two and I’ve got X number of dollars owing on my taxes. Let’s assume I’m a self-employed guy, there’s no corporations or anything but I owe this tax personally. What’s my thought process, where do I start?

Ted M:  Here’s the funny thing about this. Most people once they get behind on their taxes, they become too afraid of the taxman to do anything about it. And that’s probably the worse response that you could have. The longer you let this problem go, the higher the number’s going to be. The interest penalties from the taxman are absolutely obscene. It’s 1% per month for being late. And if you’ve been late for more than a month they double that so it’s 2% per month. That’s like a high interest credit card.

The correct answer is always to recognize okay I’ve got this problem, I’ve got this debt with the government and now let’s do something about it. We need a fresh start so you can move on.

Doug Hoyes:  So, what are the different options that I’ve got then? I guess the first option is to pay them?

Ted M:  Right if you’ve got the money sitting in the bank you can certainly pay them.

Doug Hoyes:  So, if I owe, I don’t know, $20,000 or $30,000 can I go to CRA and say okay look I’ll give you $500 a month for the next two, three, four years and pay you off that way? Will that work?

Ted M:  Yeah so a CRA collector will tell you that yeah you can take 12 months to pay off a debt for any kind of tax arrears. And if they go to their supervisor you can probably get 24 months although they’ll be reluctant to do it. Anything beyond that, and it’s probably not something you can do without some sort of formal procedure, a proposal to creditors is the most obvious solution if you want to make a payment plan. Or perhaps you should be looking at bankruptcy.

Doug Hoyes:  So if I can pay it off in 12 months then I can deal directly with them.

Ted M:  That’s right.

Doug Hoyes:  And so how do I do that? I just phone them up and say here’s what I can do and I’ll send you a bunch of postdated cheques?

Ted M:  Yep, that’s the most common example.

Doug Hoyes:  Okay. And that’s what you would recommend then? I mean obviously you don’t want to be having to do a bankruptcy or consumer proposal if you don’t have to.

Ted M:  If you’ve got the money to pay your debts, you should pay your debts. It’s very simple.

Doug Hoyes:  So, very simple then. So, let’s say I’m in a position now where that’s not physically possible. I can’t pay them off in a year. So, I’ve got two other options that you mentioned. I mean other than going, borrowing from friends and family or something. I mean if you’ve got rich relatives great, that’s what you do then. But if that’s not possible then I’m looking at a bankruptcy or a consumer proposal. A consumer proposal is a deal.

Ted M:  Yeah, where you offer to repay a portion of what you owe.

Doug Hoyes:  And if CRA is the majority creditor they are the ones who are going to decide. What are the chances that they’re going to say yes to a proposal if I’m a self-employed guy?

Ted M:  It’s actually pretty good. The thing that causes CRA the most grief, where they automatically say I’m not going to consider your proposal is if you don’t file your returns. So, if you’re somebody who has gotten behind and then buried your head in the sand you just become so afraid of the fact that you owe taxes that you haven’t filed your last year, your last two years, the last three years. The first thing you’ve got to do is get that stuff filed so they know what it is that you owe them. If you haven’t filed your returns then CRA is not going to agree to any terms of proposal, they’re simply going to say no.

Doug Hoyes:  And as we talked about in the first couple of segments with Scott and Ian, it’s a good idea to get a bookkeeper, somebody who knows how to do it if filing taxes aren’t your thing, so, if your returns are up to date, obviously you owe money, CRA will accept a proposal in a lot of cases if it’s reasonable.

Ted M:  That’s right. And usually their starting position is alright you’ve gone through the process of filing something formal, you’re exercising your legal rights, so they’re looking for as an opening offer, the basic tax.

So, let’s say you haven’t paid your taxes in three or four years and now you owe them 35, $40,000. Probably half of that’s interest in penalties. So if you owe them $40,000, they will say the basic tax is $20,000 and that’s what they’re looking for as an opening offer and proposal. Now most creditors, Canadian banks, credit card companies, financial institutions are looking for more than they get in a bankruptcy or about a third of their debt. And so, as trustees if we were making an offer to CRA we would say alright we’re going to offer a third of the total debt so we’re not – we’ll do the calculation to figure out what the basic tax is. But you’re going to offer them something less than that. So, the basic tax is their opening position, a third of the debt is our opening position and then we usually end up somewhere in between.

Doug Hoyes:  And I guess to close the segment the obvious advice here then is come in to talk to someone who actually understands all these permutations, can help you tell what kind of amounts need to be offered. That’s where you go in. Obviously, it’s better when you can pay them but it’s better if not there are other options, a consumer proposal being one of them.

Great. Thanks very much for being here Ted. That was the Let’s Get Started segment. We’ll be right back to wrap it up here on Debt Free in 30.

Announcer:       You’re listening to Debt Free in 30. Here’s your host Doug Hoyes.

Doug Hoyes:  Welcome back. It’s time for the 30 second recap of what we discussed today. On today’s show we discussed debt problems that can arise from being self-employed or running your own business. Ian Martin explained that the starting point is to be adequately financed. Scott Schaefer discussed why it’s important to crunch the numbers and confirm that your business is generating positive cash flow even after accounting for taxes. Ted Michalos explained the options for dealing with business debt. That’s the 30 second recap of what we discussed today.

So, what’s my take on operating your own business? Well, this is one topic I know a lot about ever since Ted Michalos and I started Hoyes Michalos & Associates back in 1999. There are some big advantages to being the boss but you are responsible for all aspects of running a business. So, the advice I give everyone who was thinking of going out on their own is to start by getting some professional advice. Unless you have no choice don’t just quit your job and start your own company. Talk to a good accountant and perhaps even a lawyer. Figure out in advance exactly what you need to stay on side with the government and your other creditors.

I’ve personally dealt with hundreds of people who become self-employed but don’t know how to keep the books and a year or two into it they find they’re filing behind on taxes and filing HST returns and then they’re playing catch up. It’s no fun trying to come up with a bunch of money to pay CRA. Do yourself a favour and get your books set up correctly at the start and save yourself a lot of hassle later.

If it’s too late and your business wasn’t as successful as you had hoped and now you have a lot of debt, well again speak to a professional. There may be actions you can take on your own to get back on track. Maybe a consumer proposal or even a business proposal is necessary to deal with your debts. Take action now because business problems don’t usually get better on their own.

5 Ways To Survive Without a Credit Card

J. Douglas Hoyes

Posted in Loans and Borrowing

Reading time: 4 minutes

Hoyes, Michalos & Associates Inc. - Hoyes, Michalos & Associates Inc. | Ontario Licensed Insolvency Trustees
Survive without a credit card video play thumbnail

Most people would agree that it’s almost impossible to live without a credit card today. We no longer operate in a cash only society, in fact the use of cash to pay for things is on the decline in Canada.  Without a credit card you can’t easily book a hotel room or make a purchase over the internet.

If you declare bankruptcy you are required by law to surrender your credit cards.  Specifically, section 158 (a.1) of the Bankruptcy & Insolvency Act says that you are required to:

“…deliver to the trustee, for cancellation, all credit cards issued to and in the possession or control of the bankrupt.”

So if you go bankrupt, you lose your credit cards.  It’s the law.

Survive without a credit card video play thumbnail

Read Transcript

Ted: It’s almost impossible to live in our culture without a credit card. So if you’re speaking with anyone, a credit counsellor, debt consultant, a trustee, one of the things you want to ask them is, ‘how am I going to re-establish myself? How am I going to live?’

Doug: ‘If I have to travel, if I have to go with my son’s hockey team and book a hotel, how am I going to do that if I don’t have a credit card’. It’s a valid concern. My advice is well, while you are bankrupt or in a consumer proposal it’s more difficult to have a credit card, so what you’re generally going to want to do is have another family member for example get a credit card and put you on as a supplementary cardholder, you can get a prepaid credit card.

Ted: Prepaid credit cards is like a gift card. You go load it up with money it looks just like a Visa or a MasterCard and you can use it the same way. It’s not a great solution long term but it will immediately get you the credit card that you want. The better solution is something called a secured credit card. Where you put money on deposit, the lender will give you a credit limit on your credit card equal to what the money is you have on deposit, as long as you make your monthly payments the deposit is intact. Usually within 18 to 24 months they release your deposit back to you and so not only have you still got the credit card, but you’ve got money from the savings now returned to you that you can use for something else.

Doug: There are always strategies to deal with whatever the issues are, but you’ve got to focus though on is the big picture. The big picture is you’ve got a huge amount of debt that you’re not able to service, and so by filing a bankruptcy or a consumer proposal you can get rid of that debt, that’s what gives you the ultimate fresh start.

Close Transcript

Does that mean during the bankruptcy period I can’t travel, make purchases over the internet, and I’ll have to carry cash everywhere to pay for my daily purchases?  Not necessarily.

There are options that can help you survive without your old credit cards

  1. Use a debit card, and that’s what I recommend for daily purchases. It’s just as easy to buy groceries with a debit card as compared to cash or credit, and it allows you to easily keep track of your spending (it will be on your bank statement every month), and you have no worries about getting into debt (since you can only spend the money in your bank account, unless you have overdraft protection, which is not recommended while you are bankrupt).
  2. Get a prepaid credit card. You “deposit” money onto the card, and that’s all you can spend.  This is a good option because you are not borrowing; you can only spend money you have already saved.
  3. Use a supplementary card. If credit card is essential, you can ask a family member or friend to get a credit card, in their name, and add you as a supplementary card holder. It’s their card, and they are fully liable for it, so the credit approval is based on their credit, not yours.  Of course that also implies that if you overspend and don’t make the payments on the card, your friend or family member is now liable for the debt, so be very careful with this option.  I would suggest that the credit card have a small credit limit, be used for emergency purposes only, and be paid in full each month.
  4. A secured credit card is an option.  Offered through several companies, including the Home Trust Secured Credit Card, this is very similar to a prepaid credit card because you must put on a deposit with the credit card company funds in advance.  If you want a $1,000 limit on your secured credit card, you must provide a $1,000 deposit.  This is a good option because again, you can only spend the money you have already deposited.  This type of card has the advantage of beginning to rebuild your credit, because it appears on your credit report as a credit card.
  5. Save up and plan for bigger purchases. Prior to bankruptcy, debt payments were consuming a big chunk of your paycheque. Bankruptcy payments are usually much lower than what you were paying before giving you an opportunity to make better use of your budget. Here’s an easy budgeting tip: start by putting money into a small emergency fund and save for any larger purchases. Individuals who file bankruptcy are even able to begin to save money right away towards any down payment they may need that can ultimately help them qualify for a lower cost car loan or mortgage when their bankruptcy is complete.

If you’re worried about losing access to your credit cards and other credit my recommendation is to focus on the big picture.  If you choose to file bankruptcy to deal with a huge amount of debt your goal should be to eliminate your credit card debt, and not get back into debt again with more credit card debt when the process is finished.  That fresh start is your number one goal.

Then, once you have that fresh start, if a credit card is essential, consider your options and pick the option that will meet your objectives, but also prevents you from incurring new, unwanted, future debt.

Free Credit Score Comes With A Catch

J. Douglas Hoyes

Posted in Credit Repair

Reading time: 30 minutes

Hoyes, Michalos & Associates Inc. - Hoyes, Michalos & Associates Inc. | Ontario Licensed Insolvency Trustees
Two hands struggling over credit score report

The saying that ‘there is no such thing as a free lunch’ is a truism all consumers should consider whenever they are offered something for free. This especially holds true with lenders like Borrowell now offering Canadians free access to their Equifax credit score.

While you can already get a free copy of your credit report through Equifax and TransUnion, you cannot access your actual credit score without paying for it. Yet Borrowell is offering Canadians the ability to view their Equifax credit score every three months, if they sign up through their website.

So what’s the catch?

Before you can access your free credit score, you have to provide fairly substantial personal information to Borrowell, including your annual income and personal financial goals. Based on this information they will send you offers for further financial products that ‘match your profile’.

In fact , their own terms of service state:

In connection with your use of the Website or Services, we may send you marketing offers about third party financial products or services that may be of interest to you (“Third Party Offers”).

This means that Borrowell will also have access to your credit score. Up until now, Borrowell would only have the ability to view your credit score if you applied for a loan.

Again, from their own terms of service:

If you apply for a loan using our Website, you will be asked to provide consent to Borrowell obtaining a credit score or report from a credit reporting agency. By providing such consent, you consent to Borrowell Inc. and any of its service providers, affiliates (including Borrowell Fund Inc.) or agents obtaining and using credit and other personal information about you (including credit reports) from any credit reporting agency, and exchanging information with any of them, on an ongoing basis.

So if you sign up for their free credit score service, be aware that you are also agreeing to these same terms.

What’s in it for Borrowell and Equifax? Sales. By providing access to your credit score, and your financial goals (paying off credit card debt, renewing a mortgage), Borrowell can tailor debt services to you and your risk profile. For instance:

  • If you have a good credit score but carry high credit card debt, you may be pitched a debt consolidation loan. Once housing data is available through another recent partnership between Teranet and Equifax, they will even be able to tell how much equity you have in your home.
  • Have a poor credit score? They will likely offer you higher cost term loans to help you rebuild your credit.
  • Having signed up, Equifax may also encourage you to sign up for monthly credit report monitoring, which adds up to more costs for you – just by signing up for a free teaser.

Now, I’ve got nothing against getting something for free. It’s smart to take advantage of company offers, loyalty programs, points programs and the like. But when you do – be cautious. Be aware that you are providing someone with access to your personal data. Be extra critical of any promotional offers you receive and don’t let the excitement of getting something for free today, cost you more tomorrow.

Worried about your credit? For more information on credit scores and credit repair try our Free Online Video Course on Rebuilding Credit.

Enroll for Free

Podcast: Why I don’t like credit scores

Tune in to the podcast episode below.

Transcript

I’ve got a bit of a different show for you today. No guests. No questions back-and-forth. I just want to address one issue and this is, I guess, more of a rant than anything else. The question I want to answer today is why I don’t like free credit scores.

So let me break it down. I also don’t like credit scores themselves, and I talked about that in my book, Straight Talk On Your Money. I’m sure you’ve all read it, but I had to get the commercial in for it here. Myth number 4, give credit where credit is due, and I address this issue in the book, why I don’t like credit scores.

There are a few reasons. The first reason is I think we’re obsessed with them. I get people coming in to see me. They’ve got a massive amount of debt, and they say to me, okay, I realize that I’m going to have to do a consumer proposal or bankruptcy to deal with all this debt, but what’s that going to do to my credit score? Am I ever going to be able to borrow again?

And I’m sitting there thinking, well, isn’t the most important thing to deal with the debt you’ve got, rather than worrying about the future of being able to borrow again?Obviously, in a consumer proposal or a bankruptcy, once your debt is gone, it is very possible to rebuild your credit and borrow again. There are lots of people who go bankrupt and end up buying houses and cars and all the rest of it. That’s not my point.

My point is, we are obsessed with credit scores and we believe we’re not a good human being if we don’t have a high credit score. That’s my first problem with credit scores. We start doing things to make our credit score look better, rather than to make our financial lives better. I’ll explain more about what I mean about that in a minute.

My bigger problem with credit scores is that they are not for your benefit. They are for the benefit of the lender. Credit scores were created by banks to decide who they should lend money to and under what terms they should lend. So you all know how credit scores work. It’s a three digit number.

A perfect credit score is 900. There’s no such thing as a perfect score. A really good score would be in the 800s. An okay score would be in the 700s. Six hundred is bad, but once you get into the 400s and the 500s, then it becomes more difficult to borrow. You’re going to pay a higher interest rate.

So I understand why people want to get a high credit score. I totally get it. If I’m thinking of buying a house, I want to get the best possible mortgage interest rate because that’s going to save me a huge amount of money. Totally get it, I understand why people want a high credit score, but the point still remains. Credit scores were created by banks so they could decide what they should lend you, what interest rate, what to do.

Let me illustrate. And I talked about this in my book. There are two different people. Let’s call one of them Mary and one of them John. Mary has never had any debt in her life. She has saved money her whole life, and now she has a million dollars cash sitting in the bank.

John, on the other hand, has five different credit cards. He owes $10,000 on each one of those credit cards. Sorry. He has a credit limit of $10,000 on each of the credit cards, and he carries a balance of $2,000 on each of those cards. So he owes $10,000 on his five credit cards.

Who has the better credit score? Well, you would think, well, obviously, Mary is in much better shape. She has no debt and a million bucks in the bank. She’s obviously a superstar, right? Well, not according to the credit score calculation. Mary may not even have a credit score. She’s never had any debt. All she’s got is money, whereas, John is very crafty. He has five different credit cards, and he has a utilization of only 20 percent on each of them.

He’s borrowing $2,000 against each $10,000 limit. So the credit score algorithm rewards an appropriate level of utilization. So if you’re only carrying a balance of 20 or 30 percent that’s positive for your credit score. If you’re carrying a balance of 100 percent, well, you’re maxed out. That’s not good. If you never carry a balance, well, the banks don’t really like that because they can’t make money off you.

So how do you get a really high credit score? Well, one strategy is to have an appropriate utilization, say around 20 to 30 percent, which is why John will have a better credit score than Mary. Does that make any sense?

If you were a lender looking to lend someone money, would you feel more comfortable lending Mary money, who’s got a million bucks in the bank, or lending John money, who’s got $10,000 owing on credit cards and is paying, I don’t know, a couple of thousand dollars a year in interest? Well, I’d prefer to lend to Mary, but of course the banks like John because they know he will carry an appropriate amount and they’ll be earning money off him.

That’s why the banks like that level of utilization. So my point is, the reason I don’t like credit scores is they are designed for the benefit of the bank, not for the benefit of you, the borrower. And, in fact, they’re counter-productive for you because you’re so obsessed with them you try to do things to make your credit score higher, like carrying a balance on your credit card, which is just crazy.

Okay, so why – There are a couple of other reasons I don’t like credit scores, and again, we can – I talk about this in my book. One of them is that not all your payments are tracked. There may be some, student loans, mortgages, pay day loans, Revenue Canada debt, whatever, that does not appear on your credit report, which, once it’s paid off, would potentially increase your credit score.

It’s not there. I mean, I also have problems because different lenders will use different calculations. So you get your credit score from TransUnion, but you go into a bank that uses Equifax to generate the credit score, you may not actually know how you’re being evaluated. But regardless, a bunch of problems with credit scores. That’s not the purpose of this video. What I want to talk about today is why I don’t like free credit scores.

So what I’m talking about is agencies, companies that will give you your credit score for free. So let me be very specific about what I’m talking about here. You can get your credit report for free. You can send away to Equifax or TransUnion. In fact, TransUnion has an online portal that you can log in to, and it verifies and validates all your information. You can get your credit report instantly online for free.

With Equifax, you have to mail in, use the telephone. You’ve got a couple of places you can actually go in to get it. Either way it’s free, and the law in Ontario says you’re allowed to get a free credit report every year. So you can fill out the form, mail it in. they send it to you for free. You’ve got your credit report. And, in fact, in my experience, if you mail in and ask for it twice a year, they’re not going to say anything. They’ll send it to you, not a big deal. That’s your credit report. So that lists everybody you owe money to, and, you know, whether you’ve got any judgments against you, things like that. It does not show your credit score, which is that three digit number.

If you want to get your credit score from Equifax or TransUnion, which are the two big credit bureaus in Canada, you have to pay them for it. They will not give it to you for free. They run businesses. That’s how they make money. They sell people their credit scores. So how is it possible, then, that there are these other free credit score places that will give you your credit score for free? And I’m talking about places like Mogo, Borrowell, Credit Karma.

You can sign up, log in, verify your information and get a copy of your credit report and your credit score for free. So how is this possible? And again, I understand why people want to do it. We’re all obsessed I think our credit scores. So why would I pay Equifax 20 bucks when I can get it from Credit Karma for free? I totally get why people are doing it, but here’s the question you’ve got to ask yourself. If I want to get my credit score directly from TransUnion or Equifax, I have to pay for it. It might cost 20 bucks, or I can go on some recurring plan, or I can get it every month. If I have to pay 20 bucks, why is it that Equifax and TransUnion will give my credit score for free to these free credit score agencies? What kind of business model is that?

Well, I don’t know the answer for sure to that question, but my guess is they’re not giving it to them for free. They are charging them for it, but they are giving them a really good deal on it. So Credit Karma, for example, goes to TransUnion and says, hey, we’ve got all these customers. We’re going to be buying 10,000 credit scores from you for 10,000 different clients a month. What’s the deal? I assume TransUnion says, wow. We’ll sell them to you for a buck each, or two bucks each, or five bucks each, whatever it is, a pretty reasonable number.

So they can buy them in bulk and get a better deal. But still, that doesn’t change the fact that they are paying a couple of bucks to TransUnion to get my information, which they are then giving to me for free. How does that possibly make any business sense? What kind of business is that where you’re buying something and giving it away for free? Well, obviously, those free credit score companies must have another way of making money, and you all know the answer. You know what they’re doing. You sign up for the credit score. You have to give them all your personal information, including your email and everything else. You get your credit score, but now you’re on their mailing list. So now you’re getting emails. Hey. Congratulations. You qualify for a credit card. Here’s a loan. Here’s a mortgage application, whatever.

Now you think about it. If you were a credit card company and you were trying to get new clients, how could you go about doing that? Because it’s a pretty competitive market, lots of different credit card companies out there, lots of different banks. How could you get new clients? Well, one way would be, you know, put an ad on TV. Advertise on the Super Bowl. Pay a few million dollars and everybody will see your ad. Well, that’s a very expensive way to get new clients because you’re advertising to everybody when you only need to attract the certain people who would qualify.

You’re advertising to people who have really bad credit and you’re not going to give them a credit card. You’ve got people with lots of money in the bank. They don’t want a credit card. How can you target the exact person you want? You know what would be really helpful is if you had their credit report in front of you because, if you’re a lender and you’ve got someone’s credit report in front of you, it’s really easy to figure out what products you should be selling them. So someone’s got, nah, not very good credit. Well, maybe you’ve got some kind of credit rebuilder product, a credit card with a really high interest rate, but a low limit, not much risk. You could make lots of money on it. Maybe somebody has fantastic credit. Okay, great. You qualify for a really big mortgage, and we’ll give it to you at a low interest rate.

Having that credit information makes the lending decision very easy because you’ve got all the information, but how do you get people to send you their credit reports? Hmm. I know. Why don’t we offer them for free through these credit reporting or free credit score agencies and, as a result, we can then cherry pick and target exactly the advertising to the person we want. Well, that’s exactly what happens. If you sign up for one of these free services, you will start getting very targeted solicitations, very targeted emails that say, Hey. Congratulations. You qualify for this. You qualify for that. They will not send you something you don’t qualify for because they’ve already done all the math.

So if I’m a credit card company, this is fantastic because instead of spending $5 million on a Super Bowl ad, I can spend, I don’t know, 50 bucks to send a specific set of emails to a specific person. And if that person ends up getting my card and ends up carrying a balance of a few thousand dollars, well, over the course of the next few years, I’m going to make thousands of dollars off that person. So paying $50 or $100 to acquire a client is a no-brainer when you’re in the financial services business. So it makes perfect sense for me, the credit card company, to go to one of these free credit score places and say, Hey. Everybody you send me who meets these exact criteria, I’ll pay you 10 bucks, 50 bucks, a hundred bucks, whatever the deal is. So the credit score place, Credit Karma or whoever, can make a lot of money by buying your credit report for a couple of bucks, giving it to you for free, but then selling, in effect, access to you to a big bank or credit card company for 50 or a hundred bucks.

Now, I just made those numbers up. I have no idea what the numbers are, but obviously they wouldn’t be doing it if it wasn’t profitable. Now you’re sitting there going, okay, okay, I get it. I get it. They’re selling my information, but I don’t care. I’m getting a good deal, and frankly, I don’t have to take the deal. If they offer me some credit card that I don’t want, I can just hit delete on the email.

There’s no big deal. I mean, I’m, you know, I’m a big boy. I can, I can take it. I’d much rather have access to my free information than worry about whether I’m, you know, losing some of my privacy or not. Okay, fair comment. I mean, I kind of don’t like my information out there, but fine. But again, think about it from your point of view, not from the bank’s point of view. Think about it from your point of view. And, in fact, this happened to me last year. My bank, who I’ve been with forever, decided that the type of credit card I had, which had certain features, cash back and whatnot, they were discontinuing it. They were going to replace it with a less good card from my point of view.

So what did I do? Well, I went on the internet and started doing research on all the different credit cards that were out there, and I was able to find a credit card that was actually better for me. I buy a lot of stuff for the Hoyes Michalos business, and so, I need a certain type of card. Well, I found one that was actually a much better deal for me, better cash back, lower fees, the whole bit. So, obviously, I switched to that card. I was able to shop the entire market and come up with a card that was best for me. What would have happened if I was signed up for one of these free credit score services? All I would be getting would be offers that the bank wants to sell me. They’re not going to send me an offer for every single credit card out there. They’re only going to send me the offer for the card where they can make the most money off me. So I can decline the offer or not, but I am not being presented with all the options. But, hey, if I don’t have a lot of time to be searching around, if I’m maybe a little bit lazy, I don’t know how to go about doing the searches, maybe I end up taking a deal that I think is a good deal because it was the only deal offered to me. And I end up getting myself into something that was not a good idea for me, which brings me to what I think is the biggest problem with free credit scores.

You are the product. That’s the biggest problem with them. If someone is offering to give you something for free, that must mean that you are the product that’s being sold. And I realize that doesn’t make any sense, because I’m sitting there going, wait a minute. I’m getting my credit score from them. Obviously, that’s the product that I’m getting. Nope. You’re getting it for free. They’re giving it to you for free. So it’s pretty obvious you are the product that is being sold. Do you like that? Are you happy about that? Is that what you want? Hmm. I’m not a big fan of that.

I would prefer not to be the product that is being sold. So my problems with free credit scores, number one, I am the product. I’m being sold. All my information is now out there. There are other problems, though, too, with it. I see people all the time. In fact, I had a gentleman in yesterday who was filing a consumer proposal with me. He had downloaded his free credit report and free credit score from one of these agencies. And as I looked at it, I could see that the information on it was not completely accurate, and it was not complete. Inaccurate information, not complete, I see that all the time, and I assume that’s because when these agencies are buying the credit reports from TransUnion or Equifax, they are getting a summary version of it. It doesn’t have everything on it.

It may also be slightly out of date. It may be from a month ago, two months ago. I don’t know if they get some big data download and it’s not completely current, but I see it all the time. If you take your free credit score and free credit report and compare it to the one you got directly from Equifax or TransUnion, you would see that the Equifax or TransUnion report has more information on it, it’s more up-to-date, and tends to be more accurate.

Do you really want to be relying on something to make decisions that may not be completely accurate? I don’t like that idea. I don’t think that’s a good idea at all. The other problem is by having access to a free credit report all the time, it is much easier to obsess over your credit score. And again, I talked about this at the beginning. I think this is a big problem because it makes us do things that we would not otherwise do. So I’ve decided I want to try to get my credit score as high as possible. So now what I could do is do little tests and see what happens. So okay, I’m going to go out and apply for a credit card. Let’s see what that does to my credit score. Oh. Look at that. It made it go up by 10 points. That’s interesting. Okay. Now I’m going to apply for a credit increase, a credit limit increase on one of my credit cards. Does that make my credit score change or not? Well, I can do the test, and then check my credit score again and see if it made any difference. Okay.

Now I’m going to try carrying a balance. So I always paid my credit cards off in full every month, but now I’m going to try carrying a balance. Let’s say if I carry a balance of 500 bucks, a thousand bucks, 1,500 bucks, 2,000 bucks. I’ll keep pushing it and see at what point my credit score continues to go up, at what point it stops, at what point it goes down. So I can – It’s kind of like fine tuning an engine in a car. I can, I mean, I guess, car engines are all computer controlled now, but back in the day, you could get your, you know, screw driver in there and adjust the carburetor, and tune however you wanted. Well, it’s kind of the same with a credit score. I can try different things and see how that impacts it. So, okay, I want to finance a car in six months. I want to get my credit score as high as possible.

So I’m going to apply for a couple of different credit cards, I’m going to start carrying a balance, and I’m going to see how that increases my credit score. I’m gaming the system. Hey, great, power to the people, right? Let’s show the banks that two can play at this game. Okay. Again, I get it. But are you not worried about that fact that you are carrying balances on your credit cards and you are paying interest on those balances that you are carrying? So you’ve made your credit score go up, maybe, but you’re also paying out all this interest, which is money that you don’t have in your savings account now to use as the down payment on that car you want to buy. Have you actually done yourselves any favour? Hmm. Again, I’m not a big fan of it. So I don’t like free credit scores because you’re the product.

It makes it too easy to obsess over them. And sometimes a lot of the information just isn’t accurate or complete. So, okay, what’s my advice, then? Am I saying just never look at your credit report and don’t worry about it? No. I live in the real world. I fully understand that if I want to finance a car or buy a house, I’m going to have a good credit score or other supporting information that is going to make it favourable so I can get the best deal.

So what I would do, my advice is to focus on what is good for you, not what is good for the lender. That’s my advice. So if you want to check your credit score, okay, great. I mean, checking your credit report, I totally agree that’s something you should do, you know, a couple of times a year. My advice to people is, at the beginning of the year, get your free credit report from Equifax, and then in the summer, get it from TransUnion, and then at the end of the year, get it from Equifax again.

So every six months you’re getting a credit report from either this agency or that. And because they’re required to give you a free one every year, if you get one from each agency, you know, every six months, you’re getting a fresh report every six months.

And as I said, you can usually apply for them more often than that and it’s not a big deal. There are some banks that automatically will give you your free credit report and your free credit score as part of your banking relationship. I believe at the moment, and I’m recording this in April of 2019, so if you’re watching this at some other date, the information may be different, but I believe that at the moment Scotiabank and Royal Bank offer their customers, or certain customers, a free credit report and a free credit score. So there’s a way to get it for free without disclosing a whole lot of additional information because you’re already with the bank anyways.

Your credit report probably tells you everything you need to know. The credit score is a lot less important. What would make your credit score look bad? Well, if there’s a debt showing up on your credit report that you haven’t paid. Maybe you’ve got an old cell phone bill from a year ago that you totally forgot about. You thought you’d paid it, but it’s showing up on your credit report as unpaid. Well, a pretty simple solution, then. You call up the cell phone company. Make the payment to them. That’ll clean it up on your credit report, and your credit score is going to go up.

You don’t need to see your credit score to know that if there’s an error on your credit report, you just need to get it fixed, and that’s automatically going to make your credit score better. So advice number one, get a free copy of your credit report, correct any errors that are on that, and that’s going to have a big impact on your credit score. My second piece of advice would be only get your credit report or your credit score if you actually need it. So, okay, I’m planning to buy a house in three months, six months, whatever it is. It’s a big purchase. So I was really like to know what my credit score is. Okay, fine. If your bank doesn’t offer it for free, then, okay, pay the 20 bucks and get a copy of it so that at least you know what’s showing up at that particular credit reporting agency.

Now I know you could just sign up for the free service and get it forever for free, but you then put yourself at risk of getting all these solicitations, and, you know, your email box is clogged up and you’ve now given your private information around to everyone. So if you really, really want to see it, fine. Pay it. You don’t need to be doing it every two weeks, though. Get it. See what’s on it. Correct it.

So I would get my credit report first, correct any obvious errors, and then once they’re corrected, then I would pay for my credit score if I really wanted to see it. In my case, I don’t care if my credit report looks good. I assume my credit score will be good, but then if you really are obsessed with it and want to know, well, get it once and then you’re at least not looking at it all the time, which brings me to my final piece of advice, and that is don’t obsess over your credit score. Having a good credit score does not make you a good human being. That’s not how life works. Do what’s right for you, not the lender.

So, save money. Get out of debt. Those would be the top two things, and I guess it’s in the reverse order. Get out of debt and save money. Those are the top two things. So if you came to me and said, oh, I’d like to make my credit score as high as possible, I would say that’s the wrong objective. I think your objective should be, I want to be as sound financially as I can. Some day, I want to be rich. Okay. Here’s my advice. Get out of debt. Do whatever you can to pay down debt.

There’s no sense in paying out interest if you don’t have to. And I realize that’s easier said than done, but in a lot of cases it means okay, maybe I do have to file a consumer proposal. Maybe I do have to go bankrupt. Because there’s no way I can ever pay back that debt. And yes, it’s true. That will cause a hit to your credit score. There will be a note on your credit report that says you filed a bankruptcy or proposal, but you’ve eliminated all your debt.

So now you can start saving, start rebuilding. So in the future your credit score will actually be higher, ultimately, than what it is today. So deal with your debt, and then once the debt is gone, start saving money. So think of it this way. I want to go to the car dealer, and I want to buy a car. I want to finance it. So I walk in there and I say here’s the car I want to buy. And so, they punch it into the computer and go, oh, your credit score, it’s not that great.

You know, you don’t have a whole lot of credit. You don’t – You pay your balances in full every month. So the bank hasn’t juiced up your credit score. Okay, but guess what Mr. Car Dealer person? I have here $5,000 as my down payment, and look, I’ve got a job. I’ve got a good income. I’m a pretty good risk. I’m pretty sure you’re going to be able to get the car, regardless of whether your credit score is here or here because you’ve got a down payment. You’ve got an income. That is more important than whether you’re carrying balances on three or four credit cards.

So do what’s right for you. Don’t be focused on doing what’s right for the lender. That’s my advice, simple as that. Again, if you want to get your free credit score, no problem, but just understand the information is not always completely accurate. It’s not always complete. It’s not the exact credit score that the lender you’re dealing with might be looking at anyways.

So you’re putting your personal information out there, and unless you’re super highly disciplined and you can say no to whatever offers come your way, you run the risk of doing things that are actually counter-productive. Look out for you, not the bank. That’s my advice. I hope that helps. Thanks for watching and listening. Until next week, I’m Doug Hoyes. That was Debt Free in 30.