As anyone who follows me on Twitter knows, I can be quite passionate about financial knowledge people should have but may not. I also know financial literacy is hard. It’s not just math – it’s time, it’s information, it’s awareness, it’s behaviour.
Given all that, it’s no wonder debt has been a problem in Canada for years. Canadians owe a total of $2.3 trillion. More Canadians are suffering from debt vulnerabilities; something brought to light by COVID-19 and the economic downturn. Millions of Canadians deferred and skipped payments, finding out they could not pay their bills beyond one single paycheque. And existing debt loads had a lot to do with that.
From credit cards to mortgages and car loans, debt comes from many different places. And it accumulates because most people endure the same obstacles when it comes to avoiding and overcoming debt.
I scrolled through my past twitter feed for the common barriers to paying down debt and reasons why people find themselves in financial difficulty. If you want to learn something about managing debt and how to solve debt problems, this is a good place to start. Shoutout to all the teachers out there looking for financial literacy curriculum, this is what I’d make sure my kids learn. I also provide some tips on how to overcome barriers.
Table of Contents
Common barriers to paying down debt
1. Lack of real personal finance knowledge
How did you get into debt anyway? I ask that question a lot, and you would be surprised at how many people don’t know the answer.
Some forms of debt, such as a mortgage, are inevitable (more on that later). Most people don’t have the funds to buy a home in full. But other forms of debt, such as credit card debt, subprime installment loans, high-cost car loan debt, and tax debt, could easily be prevented with some basic personal finance knowledge about how credit and debt work.
Credit ratings in insolvency
Future credit impact of insolvency
Tax debt in insolvency
Statutes of limitations
Consequences of bankruptcy
Secured vs unsecured debt
You credit affecting others
(I could go on) 2/#FinancialLiteracyMonth
— Scott Terrio (@ScottTerrioHMA) November 1, 2018
My top ‘must know’ personal finance lessons for anyone wanting to avoid making big debt mistakes are to learn:
- The implications of joint debt and co-signing a loan and what happens when the primary borrower defaults.
- Cars are a killer financially. Be aware of the total costs of borrowing, interest as well as repairs and maintenance.
- Understand how credit scores work and how your credit decisions affect both your finances and your credit score.
- What rights a creditor, and by extension a debt collector, have to collect an unpaid debt. People should understand a bank’s right of offset and the statute of limitations.
- Learn how income tax works.
- Take a basic accounting course if you are running a small business – separate personal debt versus business debt.
2. Bias in decision making
Psychological or cognitive bias is our tendency to make decisions based on emotion over logic. We make decisions that make us feel positive, even if the outcomes turn out to be bad for us. Think of buying that bigger house, that nicer car.
What makes things worse is not just the wrong initial decision, but the fact that the system is set up in such a way that reversing the decision can cause further financial stress.
We base so many daily financial decisions on mental shortcuts used to ease cognitive load. We sub tough questions w/ easier ones. Emotional calls vs logical ones. They get us into trouble later b/c poor $ choices are hard to undo – the system isn’t made for you to recover easily.
— Scott Terrio (@ScottTerrioHMA) July 6, 2020
Here is a typical example. You decide to downsize, finally admitting that you can no longer afford your mortgage payments. You decide to sell and rent for a while. The problem is that your mortgage comes with a significant prepayment penalty. This penalty adds to the financial cost to undo a bad decision.
Another example we see every day is high-interest financing loans. The easy decision is to get another loan to deal with cash flow pressure. Maybe a payday loan, but just as poorly those 39% and 49% subprime installment loans. They solve the crisis right now, but the cost down the road is often the final killer to someone’s finances, and all too often, this leads to filing insolvency.
The best way to get rid of bias in your financial decisions is to consider the alternatives and look further into the future. What could my finances look like in 10 years if I don’t buy that house? What are my alternatives to that high-cost loan? Don’t act rashly; think twice before signing on the dotted line.
3. Unexpected expenses
According to a Canadian government study on financial capacity, 64% of Canadians have an emergency fund to cover unexpected expenses. This seems surprising given how many people were one paycheque away from missing their rent or mortgage payment after COVID-19.
It’s hard to save up money if you’re in debt. Emergency spending on car repairs, housing costs, even pet bills often means borrowing more to pay the bills and can put you further behind on debt payments.
Your priority should be paying off your debt; however, emergencies are unavoidable. You should save up a little bit of money every week. Include saving as part of your debt repayment plan. Again, this takes a little knowledge and thought. You absolutely should pay off any high-interest debt before focusing on savings. But a small emergency fund is likely better for you strategically than making an additional mortgage payment.
Most we meet w/ have used credit for unexpected events for which they had no cushion to ride out. Or to make ends meet on realistic expenditures which add up. Debt is habitual. And the human psyche ignores the mountain that is building. Very few set out to run up $75,000 in debt.
— Scott Terrio (@ScottTerrioHMA) June 24, 2019
4. Lack of consistent income
Inconsistent income and employment make overcoming debt nearly impossible. Roughly one-third of people who filed insolvency in our 2019 study sited job-related issues as a primary cause of their financial problems. Interestingly I don’t expect that will change a lot in 2020 – insolvencies are down despite the current economic slowdown, and those who are filing now are still working. But wait until 2021, when most of the economy reopens and more jobs come back. Those insolvencies will have been triggered by those out of work during the pandemic. This is just part of the long-term insolvency cycle. Without savings, we use debt to survive when our incomes drop, and we slow debt repayment.
The gig economy has also had a lot to do with this trend. More employers are offering contract work instead of steady employment. A gig worker won’t necessarily earn the same amount of money each month, making budgeting and debt elimination more arduous.
This one won’t get the headlines, but it’s huge:
“The gig economy is now the main income for one-in-seven Canadians” pic.twitter.com/5n0OGwkDVh
— Scott Terrio (@ScottTerrioHMA) December 4, 2018
You need to budget differently if you earn variable income.
First make sure you set aside enough to cover your potential tax obligation. ‘Borrowing’ from your future tax liability is just a bad idea.
Next, pay yourself a fixed salary. Don’t live feast to famine just because your income flows that way. Make a budget for the downside and live like that until you’ve built up enough cushion to risk spending more.
And above all else, don’t treat your line of credit as an income source. I can’t tell you how many people view their HELOC as extra income rather than what it is, debt.
5. Compound interest and high rate loans
Interest is a hard concept to visualize. Even if you tell someone the interest rate on their loan is 39%, if they can afford the monthly payment, they often discount the impact of that high rate on their borrowing decision.
High rate installment loans can more than double the amount someone has to repay on a 5-year loan. Most of these loans are taken out by people who have a cash flow crisis. Just consider how hard it is to repay that debt when you have to pay back more than double what you borrowed.
Total amount financed: $10,737.90
Cost of Credit: $14,224.50
Total owing: $24,962.40
Interest rate: 39.99%
That sound “Fair?”
— Scott Terrio (@ScottTerrioHMA) December 13, 2019
When taking out a loan, pay attention to more than the monthly payment. Unfortunately, lenders know this is the only number most people consider. Online loan calculators by the big banks, like this green one and this red one, don’t even tell you how much you will be paying in interest over the life of the loan. The only ‘relevant’ information they give you is your monthly payment. Instead, use a calculator that shows you the total interest you will be paying over the life of the loan. I’ll give credit to this blue one that does just that.
Ask yourself what impact paying all that interest is going to have on your future cash flow and the ability to pay off other debt or build some savings.
6. Not making enough money
The average insolvent debtor takes home roughly $2,700 a month, just under half that of the average Canadian. Not only does not earning enough make it hard to pay off debt, but lower-income earners are much more likely to accumulate problem debt. I’m talking about the working poor. They have just enough income to earn credit, but not enough to pay back the debt. That’s why many expect to be in debt for life.
In my experience, very few people frivolously spent their way into bankruptcy. What we see is people using their credit cards to pay for every day living expenses. Once they owe money, debt payments aggravate an already bad cash flow problem.
This issue is particularly true for recent graduates, stuck in lower-paying positions, unable to find employment that pays enough to pay the rent and pay back student loans. Add in a minimum wage that’s below a living wage, and you have a large segment of society using credit to make ends meet.
Lessons 1 through 7 in Financial literacy
Figure out a job you can tolerate that PAYS WELL
May not require higher education, maybe apprenticeship but don’t fall into the low income trap
If you’re 25 in a $17.50 an hour job you MUST figure a way to move up
— Ron Butler (@ronmortgageguy) June 24, 2020
It’s cliché, but if asking for a raise isn’t an option, try to find additional work. A second part-time job or a side gig are great options, but as I said before, watch out for the potential tax hit. As pointed out by Ron Butler (@ronmortgageguy), if you are young and working in a low wage job, the best you can do for you finances is find a way to move up the ladder. Find ways to improve your skills, but don’t count on higher education being the secret sauce that ensures a large income. If you are going to go in debt for student loans, run some numbers and seriously look to your future employment potential.
7. Family Demands
This is a big one. Beyond the obvious – the cost of daycare for example – one of the riskiest family burdens is the demand for financial support.
It’s an American study, but nearly half of parents who made the decision to help their adult children financially say doing so put their retirement at risk.
And you are not necessarily doing them any financial favours either. Helping your kids borrow more than they can repay sets them up for serious financial problems down the road.
Borrow another $10-30 grand fromfamily (who are HELOCing it you know very well) to ensure you get into an insured mortgage to keep the monthly payments you can’t afford at a level you can not afford slightly less. But keep an eye on your future ability to pay it BLAH BLAH
— Scott Terrio (@ScottTerrioHMA) June 17, 2020
8. Low interest rates
It may seem odd to put low interest rates on a list of why people can’t pay down debt, but low rates are the primary reason why we have so much household debt. You’d think low rates would mean we’d pay off debt sooner, but the opposite is true. A low cost of borrowing just feeds our demand for more, not less debt.
Low interest rates make large assets appear more affordable. The lower the rate, the more willing we are to borrow large sums of money to buy bigger houses, nicer cars, boats, etc.
This is made worse by the fear of missing out. FOMO culture is at its highest, and it’s more than just housing. Low rates are funding lifestyles. Keeping up with the Jones seems easy when rates are almost zero on your HELOC, and banks are willing to extend you terms of 8 years or more on a loan to buy something new and shiny.
Wake boat: $92,000+
Pontoon boat: $26,000
3 jet skis: approx. $30,000
All new this spring.
That’s on one dock. And they are salaried people. Nothing crazy.
And I’ve seen this on many docks just today, as well as last week. Phenomenal. The shutdown bounceback.
— Scott Terrio (@ScottTerrioHMA) July 3, 2020
And the housing boom just feeds the beast. “Will I be able to buy a house?” No matter their financial situation, this is a question I hear almost every single day. Poor credit – still want to buy a house. Piles of unsecured debt – no problem, still want to buy property.
$78,000 in unsecured debt
Income: $3,800/ mo net
Family of four. Toronto.
Credit: funding basics.
Concerned with ruining their account standing with Big 5 bank if they file a proposal. Gotta buy a house some day.
— Scott Terrio (@ScottTerrioHMA) June 16, 2020
The result is Canadian households are high in debt, asset rich, but cash poor. Canadian families have a liquidity crisis that means they are unable to weather any sudden shock – a job loss, unexpected expense, life events like an illness, or divorce.
Don’t buy a house because everyone else is. Buy a home because it makes sense for you – and that means having the financial security to manage through the downtimes as well as the good.
9. Making only minimum payments
The saying “cash is king” should probably read cashflow is king when it comes to borrowing. Borrowing is a way of using tomorrow’s dollars to buy something today. However, we overextend ourselves when you use up too many tomorrows.
Minimum payments put debt repayment on the never, never plan. When you only make minimum payments on your credit cards, you are decreasing your debt by such a small amount that your balance barely moves. Yet people I meet with piles of credit card debt are proud to tell me, “I’ve never missed a payment, and my credit score is good”. True, but your finances are a mess, and clawing your way out at 19% is difficult.
Minimum payments only: 33 years, 7 months, on a balance of only $3,889#EstimatedTimeToPay
— Scott Terrio (@ScottTerrioHMA) January 11, 2019
10. Car loans
What I do see a lot is big-ticket purchasing mistakes like cars.
Car loans and leases are a common entry point into long-term financial trouble.
We buy more than we can afford because we focus on what we like, and what the monthly payment will be. The total financing costs and future operating costs don’t fit in with our initial decision to buy. Transportation costs should account for no more than 15-20% of your budget. And that’s all in – gas, insurance, repairs, and payments, including interest and principal.
Net monthly income: $3,140
Car lease: $675
Total car cost: $1,302
% transport costs of monthly income: 41%
Car value: $36,000
Total owing: $37,000
— Scott Terrio (@ScottTerrioHMA) June 23, 2020
And this is another one of those examples where your initial debt choice makes getting out of debt difficult. You opt for an 8-year car loan or lease. Towards the end of the term, your car is giving you trouble, so you decide to upgrade. The problem? You still owe money on your original financing agreement. The solution? Roll the old car loan debt into the new. Car loan rollovers create a cycle of bad debt that is difficult to break.
How to overcome the barriers to solving your debt problems
First and foremost, avoid debt where you can. There really is no such thing as good debt or bad debt. There is a debt you can afford, and the debt you can’t. If you can’t keep up with the payments for at least three months of lost income, you may have a future financial problem even if you think you don’t today.
Remember, it’s hard to get out of debt once you are in.
While you’re in debt repayment mode, refrain from borrowing more money. In other words, don’t put more money on your credit cards, buy a home, or buy a car.
A new loan can help you solve debt problems related to high-interest debt such as credit card debt or payday loans, but only if the rate is less than what you are paying now. A debt consolidation loan doesn’t solve the underlying issues that got you into debt in the first place. It does not correct budget problems from over-spending or insufficient income.
Fix any problems impacting your credit report, but don’t feel like you need to chase a better credit score. Catch up on any overdue payments and correct errors that appear on your credit report. Pay down high revolving credit balances. Keep your credit card balances at 30% of their credit limit. Don’t take on debt just to improve your credit score. Remember, unnecessary debt is bad for your finances.
The most important thing you can do for your finances when you are in debt is to make a debt repayment plan. This is where you prioritize the debts to pay off first, figure out how much you can afford to repay and how long it will take to get out of debt. If you struggle with debt repayment, reach out to a professional like a Licensed Insolvency Trustee to talk about options for debt relief.
The benefits of paying off your debt
Carrying high levels of debt is stressful. If you fall behind on payments, you have the added stress of constant calls from creditors and collection agencies.
Even if you are on top of all your payments, carrying debt limits your future financial potential.
I’ve met with two people in the last 3 weeks who were working 6-7 days a week to make minimum payments on credit card debts. They are now in proposals and are back to working 5-day weeks. Stress level way down. Life resumes.
— Scott Terrio (@ScottTerrioHMA) November 18, 2019
There are many benefits to eliminating debt:
- Decreasing your debt now means you’ll have more to invest. Put compound interest to work for you by building your savings and setting money aside for your retirement.
- Reducing your monthly debt servicing costs is like earning free income. You’ll have more cash flow to enjoy life.
- Want to improve your credit score? Lower those revolving debt balances. Too much debt is bad for your credit score. Keeping your balances low helps both your credit score and your finances.
Steps to paying down debt
While financial and lifestyle barriers may prevent you from decreasing your debt, there are steps you can follow to pay off your debt. I mentioned how to overcome these barriers, but there are other actions you can take now.
Create a budget
The purpose of a budget is to create a plan that prioritized how your money is allocated, including debt repayment. And that budget needs to be balanced on your income and cash flow, with no additional credit.
Pay off the most expensive debt first
Paying off high-interest debt first saves you money on interest, allowing you to put more money towards the principal so you can get out of debt sooner.
Use work bonuses and tax refunds to eliminate credit card debt
The easiest way to pay off your credit cards quickly is by taking any extra earned money and putting them toward your payments. For most people, this includes work bonuses and tax refunds. Avoid the temptation to spend that money on something else.
Delete your credit card information online
Did you save your credit card information on your browser or other retailers? Deleting that information will make it harder to spend money online. Remember, a lot of the reasons we spend is behavioural. The easier it is to buy, the more we spend.
Build an emergency fund
If you are living paycheque to paycheque, find a way to put some money aside for those inevitable emergencies. At a minimum, you want enough to avoid that high-cost payday loan.
Get help from a professional
If you have multiple debts and need help building a repayment plan, talk to a trustee about options include debt consolidation or a consumer proposal. Don’t be afraid to reach out for help. The credit industry has conditioned us to believe that filing a bankruptcy or consumer proposal is catastrophic. It’s not.