Popular wisdom says that personal debt builds when you live beyond your means, using credit to pay for what you can’t afford. All true, but what about the family that doesn’t live large, isn’t taking a vacation every year, yet find themselves facing a boatload of debt? Here are 5 reasons why your debt might be building faster than you think.
- Reverse compound interest. Compound interest is what causes your savings to grow the longer you lock away an investment. Well, the opposite is true for interest on debt. The longer you take to pay off your debt, the more you will pay in interest. So if your car dealer offers to drop the monthly car payment by $100 by extending the term for an additional year, understand that you will be paying much more in interest over the life of the loan and that’s money you could have used to pay off other debts.
- Robbing Peter to pay Paul. Rolling over your credit, whether it’s using one credit card to pay another or taking out a second payday loan to pay off the first, is the fastest way to debt problems you can find. Interest rates increase the more you borrow. In addition, your credit card may charge a higher rate on cash advances. Payday loans are more expensive than cash advances. The more credit you use, the more each dollar of debt costs.
- Relying on bonuses. Where an emergency fund provides savings to cushion the blow against unexpected expenses, relying on extra income to pay the bills can mean a bombshell if the money doesn’t arrive. Overtime, bonuses, gifts should never be spent or committed before they arrive. It’s much better to rely on this extra cash to pay down debt, than to rely on bonuses to pay the bills.
- You were never taught about debt. We have a poor track record in Canada when it comes to teaching financial literacy in school and it’s highly likely that you were never taught just how debt and compound interest works. Not the math necessarily, but the general concepts. It’s important to learn how interest-free grace periods do and don’t work, and how minimum payments will keep you in debt longer. The Financial Consumer Agency of Canada has a great guide on understanding your rights and responsibilities when it comes to credit card debt.
- You don’t know how to get out of debt. This last item is something I see every day. People come into our office having battled overwhelming debt for months, if not years. Many take out more debt just to cover their existing debt payments. Others turn to disreputable debt consultants in an act of desperation to deal with their debts and avoid talking about bankruptcy. The best way out of debt is to build a plan. That may mean creating your own debt repayment timeline or it may mean talking to a professional about your debt relief options.
The bottom line is the less debt that you have, the more money you have left in your pocket. Understanding how debt works is the first step to keeping debts manageable or getting help when you need it.