Here’s a bold statement for you: debt levels don’t matter.
Because it’s not the level of debt that causes the problem necessarily. It’s whether or not you can service it.
On our year-end review show #174, we gave the example of someone with a $500,000 mortgage and 25-year amortization. If the interest on it went from 3.29% to 4.29%, the monthly payment would go from $2,400 to just over $2,700. That’s about an 11% increase. Would you be able to afford an 11% increase? Would your salary go up by that much? If you can afford it, then great.
It’s not the actual debt amount that matters. It’s your ability to keep paying it down, especially when interest rates go up.
High dollar or high interest debt?
There are two ways to approach this. Ted and I would suggest paying down your most expensive debt first – which would be the one with the highest interest rate. The reason for it is you get the most “bang for your buck.” Say, for example, you owe someone $1000 at 30% interest or you $1000 at 10% interest. Paying down the 30% will save you money in the long run. Also, the faster you pay that debt off, the more money you can direct towards the lower interest debts. It’s simple math, really.
On the other hand, Ted and I both understand that things aren’t always dollars and sense. You might feel more accomplished from having paid off a smaller debt load faster. It’s definitely motivating. So, maybe instead of paying off that $3,000 credit card at 20% interest, you pay off the $300 phone bill because it’s smaller and takes less time. Now that it’s paid, you’ve achieved a goal and you can move onto the next.
If it’s something you can pay off in a month or two, OK, fine. If it’s something that’s going to take you a year to pay off and you’ve got another debt that’s at a much higher interest rate, then the psychology isn’t quite the same.
Say you’ve got a line of credit with interest at 8%. You also have debt on credit cards at much higher rates. If you still have room in your line of credit, it might make most sense to max out the line of credit to pay off your credit card debts. This way, you’ve achieved a couple goals: your high interest debt is paid off and you’ve reduced the total amount of debt owed.
The same goes for a debt consolidation loan. If you can get a lower interest rate that’s fine. Don’t just extend and pretend. In other words, don’t take out a long term loan or add to your mortgage to lower your payment if you can’t afford that debt when rates go up.
Be aware, this method only truly works if once you pay off that credit card debt, you actually cancel cards too and don’t accumulate more debt.
When balances are too large
However, if you find yourself overwhelmed with debt, and you’re unable to pay it down, we’d suggest speaking to a professional as soon as possible.
The biggest mistake people make is that they avoid the problem and problems don’t go away, they come to us when it’s too late, their options are much more limited.
A Licensed Insolvency Trustee (LIT) would be the place to start because we’re obligated to tell you all your debt relief options, not just the ones we provide. It’s the law. But, the most important thing is to seek debt help early because you’ll have many more solutions available to you. For example, you might qualify for a debt consolidation loan from your bank. Or, you could go through a debt management plan with a credit counsellor. For some, however, a consumer proposal might end up being the best solution. In any case, the earlier you get help, the better it is for your financial situation.
For more on which debts you should prioritize when paying down debt, listen to our podcast.
Resources Mentioned in the Show
Straight Talk on Your Money by Doug Hoyes
FULL TRANSCRIPT – Show #175 & 207 Which Debts Should You Pay First?
Originally aired January 6, 2018; Rebroadcast as part of Best Of Show August 18, 2018.
Doug H: Last week here on Debt Free in 30 Ted Michalos and I gave our predictions for 2018. We predicted that Canadians debt levels would continue to increase but more importantly if interest rates continue to rise, and we think they will, it will cost a lot more to service your debt. That’s the key point. Let me shock you with this statement. Debt levels don’t matter; owing a million dollars isn’t a big problem if you earn 10 million dollars a year. If you only earn $10,000 a year owing a million dollars is a big problem because you can’t service the debt. It’s not the level of debt that matters; it’s whether or not you can service it. On last week’s show we gave the example of someone with a $500,000 mortgage with 25 year amortization. If the interest rates goes from 3.29% to 4.29%, which is only one point, the monthly payment goes from about $2,400 to just over $2,700 a month. That may not sound like a lot but that’s about an 11% increase.
Let me say that again what the economists call a 100 basis point increase in interest rates, or what we normal people think of as a 1% increase, is actually a 11% increase in the example I just used. Can you afford an 11% increase in your mortgage payments? Do you think your pay will go up by 11% this year? That’s why interest rates are so important then why you should focus on debt service costs and not just the total amount of debt. So, if you have a mortgage should you try to pay it off? What about your other debts? It’s the start of a new year so which debts should you pay off first? That’s the question we didn’t have time to answer last week so Ted Michalos has returned today to help me answer that question, Ted welcome back.
Ted M: Well, thanks for having me.
Doug H: So, what debt should you pay first, what’s the thought process?
Ted M: Well, let’s make this a quick show. I think in September an excellent book was released to the public, Money Myths or maybe you can correct me on the title?
Doug H: Straight Talk on Your Money, yes.
Ted M: Yes and myth number eight was all about this particular subject, who’s the author of that book Doug?
Doug H: I can’t remember, I can’t remember. It sounds like a great book. And yes, you’re right in fact and I believe myth number 19 touched on it too.
Ted M: That’s exactly right.
Doug H: So, you’re right so let’s go through then kind of the thought process. So, the conventional wisdom – you’re right the whole point of the book is that there’s two different ways of looking at it. One side of it is pay your lower interest rates first and the other side is no, no pay the small ones first ’cause you’re going to psychologically feel better. What do you think of that?
Ted M: Well, I’m going to take us in another direction slowly. I think more important than this is to make sure you’re not accumulating any more debt. So you’re working on the assumption that I’ve got money to pay down my debt, I want to make sure that everybody understands that if you’re still accumulating debt then what we’re talking about today isn’t the solution you’re looking for we need to talk about something else, sorry about that.
Doug H: That’s a valid point because we often meet with people and they’re complaining about I can’t pay my debt, I can’t service my debt but they’re continuing to pile on more debt.
Ted M: Right so that’s – I mean you can’t solve the one problem without the other. But what we want to talk about today which debts should you pay off first? Alright, so I’m an accountant I think you pay off the most expensive debt, which is the debt with the highest interest rate. That was one of the options that she gave. The reasoning for that is you get the most bang for your buck. If you owe somebody a thousand dollars at 30% interest or somebody $1,000 at 10% interest paying down the 30% interest debt will save you money in the long run. And the quicker you pay that one off the more money you can direct to the lower interest debts. You’ll get further ahead more quickly.
Doug H: It’s math.
Ted M: Right, it’s simple math. But again, we’re accountants and I get the other side of this.
Doug H: Yeah and the other side is okay so I’ve got a $10,000 credit card that has a 20% interest but I’ve got this $200 cell phone bill from six months ago. You know, maybe the interest rate isn’t – the interest rate isn’t even accumulating anymore but it’s $200 so what’s the thought process for why you should think about paying that $200 off first.
Ted M: Well, so not everybody thinks of this in pure dollars and sense, some people think of this is a project that I got to get done. There’s a list of all these debts I’ve got to deal with and I’ve got to make that pile smaller and so one of the ways to make that smaller is to pay off some of them very quickly. Well you can’t pay off that $10,000 credit card at 20% but you could pay off that $200 phone bill. Now it’s off your pile, you’ve achieved a goal, the mountain is smaller, you feel like you’ve done something and I get that. If your brain works that way, you need those kind of little rewards then that system will work, just be disciplined enough to make sure you go through the whole pile.
Doug H: Yeah and so if it’s something you can pay off in a month or two, okay fine. If it’s something that’s going to take you a year to pay off and you’ve got another debt that’s at a much higher interest rate maybe then the psychology isn’t quite the same.
Ted M: And this will drive some of you through the loop. Let’s say you’ve got a line of credit at 7% and a bunch of credit cards and you still have room in your line of credit to accumulate more debt. It might make sense to max out the line of credit to pay off those other debts simply because it’s a lower rate of interest. Then you’re achieving both goals, you’re paying off high interest debt first and you’re reducing the total amount that you’ve got to pay every month. I know it sounds counter intuitive.
Doug H: Yeah and as a general rule we obviously don’t recommend more debt. That would only make sense if you then go and cancel that first credit card.
Ted M: That’s the critical point. So if you’re going to reduce your total amount of debt you also have to reduce your total access to credit once you’ve paid the debt down and that’s what people forget to do.
Doug H: Yeah and that’s why debt consolidation gets people into a lot of trouble ’cause okay I’ve got these high interest credit cards, I get a line of credit at a lower rate so my costs are down but I still got the credit cards. I rack them up again and I’ve got a huge problem.
Ted M: At least once a week I talk to somebody that’s done exactly that. So they did the right thing, they used their line of credit or loan to pay down all their high interest debts but they didn’t cancel their credit cards. So they went out, they ran them up again and instead of being ahead of the game six months later they’ve doubled what they owe. It’s just a bad strategy unless you do everything you’re required to do.
Doug H: Yeah it’s just very risky. And even if you call the bank and say look, I want you to reduce my credit limit for my credit card to a thousand bucks so it’s for emergencies and nothing else, there’s always credit limit creep where they just raise it anyway without your knowledge. So, I think we both agree that as a general rule, we’re accountants, follow the math, pay the high interest rate debts first. But we understand the psychology of it if you’ve got a small debt that you want to just deal with and that’s fine too, you can certainly cut it off, you can pay it off if you can do it in a short period of time, a month or two, psychologically one less thing on your pile. Okay, now what about a callable debt?
Ted M: Okay, so people may not understand what that is but a callable one that they can call you and say it’s got to be paid now, they’re also called demand phones.
Doug H: So what would be an example of that in real life?
Ted M: Most lines of credit are callable debts. They’re demand loans that they can contact you and say you’ve got to pay this thing off in full.
Doug H: So, I’ve got two different debts then and let’s say – so in the first example we talked about different interest rates, let’s assume you’ve got the same interest rate, a $10,000 credit card and a $10,000 line of credit, which is a callable or a demand type loan. And it’s kind of a silly example ’cause the interest the rates probably aren’t going to be the same but if they were, which one should I prioritize?
Ted M: Well, so the one that you’re greatest at risk is the callable debt ’cause they can contact you at any time and then say you know what, I need this thing paid off in full. So giving the example you just gave us if the interest rates were the same, I guess you’d pay down the callable debt first.
Doug H: And even if they don’t call the loan, they can change the interest rate on you.
Ted M: Exactly right but they do with credit cards too, the whole system is rigged against people but that’s a different show.
Doug H: It’s better to not have debt I guess is the answer. So, okay we talked about the interest rate differential, we talked about whether it’s callable or not, what about if it’s a secure debt. So, again I’ve got a $10,000 car loan and I’ve got a $10,000 line of credit that’s unsecured and again let’s just assume they have roughly the same interest rates, would there be any reason to prioritize one over the other?
Ted M: Well, so let’s assume you want to keep your car, you can only make one payment, either the car or the callable debt, it doesn’t matter what the other debt is. The only way to keep the car is to continue to make the payment so the decision you’re making is what’s the priority? Is the priority that I’ve got to keep the car or is the priority that I’ve got to reduce the debt. If you don’t make the car payment they have the right to come repossess it, you haven’t got the car and then they’re going to take legal action against you. If you don’t make the credit card or the line of credit payment, they have the right to take legal action against you. So, it’s a bad situation either way but if your priority is to keep the car, you’ve got to pay for the car.
Doug H: And therefore I guess in that scenario you may actually decide yeah, I’m going to pay the car loan down quicker. And again we’re giving some pretty hypothetical examples ’cause most car loans there’s a set payment you can’t – there’s no privilege to go and pay it quicker unless there’s some kind of penalty.
Ted M: And most of them have built in some kind of promotion where you’re not paying market rates anyway. I mean car companies are pretty desperate to sell cars. They give you what look like good deals but that’s another show too [laughs].
Doug H: Yeah, so you’ve paid more for the car to begin with but then they give you a deal on the car.
Ted M: Right.
Doug H: So, I guess really what we’re saying is you got to think it through.
Ted M: Yeah you know, the best thing would be to get a sheet of paper and take an inventory of exactly what debts you have, what the interest rates are on them, what the monthly payments are, that way you can figure out which ones of these is the most expensive, which one has the smallest balance I can pay off the quickest, what’s important to you to get you through this project, which is reduce your total debt level.
Doug H: And then the risk element to it. Okay, I’m really afraid of losing my car, okay then I guess maybe that’s something that gets prioritized.
Ted M: Yep.
Doug H: So there you have it a shorter episode for you today where we answered one simple question, which debts should you pay first.
Ted M: You really should get the book though, it’s very helpful.
Doug H: It’s a great book. What’s it called again? Oh yeah Straight Talk on Your Money that’s it, that’s it. And yes we do talk about this in the book. Now again, Ted and I are accountants so we like to follow the math, which says pay the highest interest rates debts first. If you have two credit cards and one as a 20% and the other is 10% allocate all of your extra money to the 20% one first because that way you’ll save the most in interest payments and of course you’re still making your minimum payments on all the other ones as well.
Ted M: Right.
Doug H: However we also understand that psychologically if you owe $100 on one debt, even if it has a low interest rate, it may make you feel better to be able to cross that one debt off your list so fine go ahead, pay it off it’ll make you feel better. It’s a small amount so the interest savings aren’t a big factor. We also think you should look at which debts are callable, if you have a five year car loan as long as you make your payments the lender can’t demand full repayment early. But if you have a callable loan, like a line of credit, or as Ted called it the demand loan, the lender may say hey, we want our money now, pay up and then you’ve got a problem. And then of course a variable rate debt, like a line of credit, allows the lender to increase your credit rate any time so there’s also a risk so that you may want to reduce your risk by paying down your callable loans, even if the interest rate is higher than on your non-callable debts.
Finally we discussed secure loans, if you don’t pay your car loan, they can take your car so again if this a big risk for you paying off secured loans first may make sense. Of course secured loans generally carry the lowest interest rate so for most people we recommend paying off secured loans first, or sorry last, not first, but now that you know the thought process you can make your own decision.
So, Ted final question for you and you kind of hit it on the beginning that you’ve got to obviously start reducing your debt before worrying about – or you’ve got to stop accumulating new debt.
Ted M: Stop accumulating new debt first and then –
Doug H: Before you start paying things off. Okay, now what if I’m in a situation though where I’ve got so much debt that it’s mathematically not possible to do it. I mean our average client has around $50,000 of unsecured debt so we’re not talking car loans and mortgages, we’re talking everything else. And even if they do the math and say well, okay I’m going to pay my highest interest rate one off first, it’s going to cost me $3,000 a month to be servicing all this debt and actually paying it off, what do you do then?
Ted M: Okay well, so when you realize you’re in deeper than you can find the way out, you need to find somebody to help you. I think, and I’m biased because I’m one of these, but a licensed insolvency trustee is a place to start. You can get an appointment with your loans office or somebody at the bank, be careful they’re going to try to sell you a new product. The newspapers are full of ads for people that, they call themselves debt consultants that will tell you they can help you get out of debt. The truth is you want to talk to the only professionals licensed in Canada to do this kind of work. And we’re obliged to tell you all your solutions not just the ones that we provide.
Doug H: Yeah ’cause that’s the law. And we have no objection, in fact we encourage you to talk to your bank or maybe they can lower the interest rate but number one make sure that that actually does you some good.
Ted M: Right.
Doug H: You know, lowering your payments from $2,000 a month to $1,800 a month when you can only afford a $1,000 a month.
Ted M: Doesn’t solve the problem.
Doug H: Doesn’t solve the problem. So understand what the options are but don’t be signing anything until you’ve fully explored all the different options.
Ted M: Correct.
Doug H: And so, when they come in to see us the common things that we’re able to help them with are a personal bankruptcy or a consumer proposal.
Ted M: Yeah, those are the legal solutions that we’re licensed to do but we also talk to people about debt consolidation loans and just revising their budget so that they can stop accumulating new debt and reduce the debt that they have. I mean only about half the people we talk to actually end up filing, we’re able to help those other folks because they come to see us soon enough. The biggest mistake people make is that they avoid the problem and problems don’t go away, they come to us when it’s too late, their options are much more limited.
Doug H: Yeah come in quickly. And so just in round numbers then so that person who owes 50, $60,000 worth of unsecured debt, credit cards, bank loans, income taxes, payday loans, that sort of thing, what kind of proposal would they end up making and obviously it’s different in all cases, it depends on income, it depends on your assets but what’s a typical one?
Ted M: A typical solution is to repay about a third of what you owe. So, on $50,000 you’re looking at 15, $17,000 so $15,000 would be $250 a month over five years. There’s no new interest charges, you’re paying down the $15,000 so you are eliminating all of the debt.
Doug H: And so it’s pretty simple math, if I paid everything on my own even if I did all the things that we discussed of paying the high interest rates first and everything, to pay off $50,000 on your own is going to cost, well even if the interest is zero it’s going to cost $50,000.
Ted M: Right.
Doug H: And with typical interest rates obviously you’re going to be paying a lot more than that.
Ted M: Yeah and I mean your guess of somewhere around $1,500 a month on $50,000 is accurate, that’s a safe bet, that’s what your minimum payments would add up to. So you compare that to $250 payment, I mean this is not complicated math.
Doug H: Now that sounds too good to be true though.
Ted M: Now remember a proposal is an alternative to filing for bankruptcy and there are times when bankruptcy makes more sense, it could be why would you agree to pay back $50,000 if you got nothing. I know that minimum wage just went up a couple of days ago but it’s still not going to be enough for people to pay off $50,000 worth of debt. That’s just not going to happen.
Doug H: And so the negative implications of filing the consumer proposal are what?
Ted M: Well, so it’s going to have an impact on your credit report but keep in mind if no one will approve you for new credit, your credit report’s already looking pretty bad. We should probably do another show on credit reports ’cause I think people are getting pretty duped on these things.
Doug H: Well we can add that to list for 2018. But yeah you’re right if you file a bankruptcy or consumer proposal it shows that you filed and so therefore that is less good than if you paid everything in full.
Ted M: But it isn’t any worse than if somebody has you in collections or if they take you to court. I mean the myth that people don’t seem to understand, I’m pretty sure this was in the book wasn’t it?
Doug H: Yeah I’m sure it was. Which book is that you’re talking about?
Ted M: That your credit report is important but it is not the end all and be all of all things. If you can’t access any new credit then regardless of what you think your credit score is or how good your credit report looks, you’ve got bad credit. I mean that’s just the truth.
Doug H: Yeah, so you said it if you can’t borrow the money at favourable rates then your credit is already shot. So you’re much better off rather than struggling with wage garnishments and asset seizure and all the rest of it trying to pay back the mountain of debt you’ve got, do something like a consumer proposal that’s going to clear up the situation.
Ted M: That’s right, it’s the start of a new year, give yourself a fresh start. If you are struggling with more debt than you can handle, talk to some professional that can at least give you options of how to deal with it.
Doug H: Well and I think that’s a great way to end it. The simple way to contact us is through our website at hoyes.com. That’s h-o-y-e-s dot com. Phone numbers for all of our different locations are there. Ted, thanks for being here.
Ted M: Always a pleasure.
Doug H: That’s our show for today. A full transcript of today’s show can be found at hoyes.com and we’ve got links to consumer proposals if you want more information and then obviously how to contact any one of our offices including how to reach Ted and I. Thanks for listening. Until next week for Ted Michalos, I’m Doug Hoyes and that was Debt Free in 30.