Thursday, February 19, 2015

Choose Your Debt Wisely

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Sinking into Debt

Sally graduated with a practical nursing diploma and currently works at a local city hospital.  Over the course of the two-year education program, Sally accumulated $30,000 in student loans. She currently rents an apartment for $1,200 monthly; her utility bills consist of the usual: power, cell phone, and cable. Now that Sally has completed her studies, she decided to purchase a new car for $35,000.  At Christmas time, she and a friend felt the need to escape the cold winter to a warmer climate.  They booked a trip to Hawaii for two weeks.  Sally didn’t have any savings for her vacation.  She charged all the expenses: hotel, airfare and meals, to her credit card.  All the quaint clothing stores had offers too good to resist.  Sally splurged another $1,000 on clothing.  Her credit card now totaled $10,000. Sally convinced herself she deserved this vacation because she worked hard on her studies. She declared this holiday as her graduation present.  Can you see the trend? 

This fictitious incident can easily happen.  Although you may think I am picking on “Sally,” the female gender, men are as guilty of getting carried away with their spending.  So imagine if Sally meets Harry who has spending habits like hers.  They decide to buy a new home and furniture, continue to take annual vacations, and replace their vehicles every second year.  The debt keeps escalating until suddenly their finances seem out of control.  

Pace Yourself

Keeping a watchful eye on debt is not only a smart strategy but also a responsible one.  Debt payments should only account for 20% of monthly income even though lenders permit up to 40%.  In the blog, Borrowing Money is Like Jumping Hurdles, you were shown how to calculate the TDS (Total Debt Servicing) ratio in order to determine your present ratio.  This information helps you understand the guidelines.

I can’t blame you for wanting everything.  Life is meant to be enjoyed.  Owning a beautiful home, travelling to far-off places to escape the winter blues, and planning your dream wedding may only be a few of your goals. You can’t run a 10km marathon in 10 minutes, why would you expect to have and do everything in 10 years when you have a life-time?  P-A-C-E yourself to avoid throwing yourself in a pool of debt and drowning as a result.        

Beware of Sharks

Choosing your debt carefully is like watching for sharks when you are fishing. You can easily get swallowed-up in debt payments.  Beware of obvious signs.

A relentless retail market constantly bombards the public with attractive advertising.  Seeing ads to finance a new fridge and stove @ 0.00% for the first 18 months is very common. Protect yourself by carefully reading the advertising materials, all disclaimers, and sales agreements.

When contemplating a home purchase, I suggest “playing house”. This sounds a bit unusual but in reality considers all the purchases which come with the title of being an official home owner.   Additional appliances or furniture may be required.  Quite often additional expenses like property insurance, taxes, the extra utility bills like energy, water and sewer are forgotten in all the hype. Then don’t forget the lawn mower and gardening tools!

While considering a new vehicle purchase, think of the payment term in months, not years.  We convince ourselves that five years is not a long time simply because counting to five can be done on one hand.  Remember five years (5) is the same as sixty monthly payments (60) or one hundred and thirty (130) bi-weekly payments. Other life events can happen in five years which may also require money to finance.  Falling in love with a new vehicle is romantic until the payments begin.  Vehicle insurance, license registration, fuel, and oil changes also need to be considered.

The smartest strategy is to eliminate one debt before taking on a new one.  For example, before considering a new vehicle purchase, focus on paying off the student loan.   Whatever you have been driving until now obviously works. If your vehicle is in dire need of repair, at the very least, look for a good used vehicle. The concern is that accumulating payments bring accumulating stress.   Avoid this road as much as possible. 

How to Avoid Drowning in Debt

Financial planners can’t stop anyone from borrowing money for the things they want. However, we can make you aware of the dangers. Your income is like a blanket which is intended to cover all your needs: lifestyle, savings, and debt obligations. Someone (or something) could be left out in the cold if your income isn’t able to do this. Do your homework first before you decide to take on debt.     

The word “old-fashioned” applies to many things: clothes, names, and lifestyle.   Although things do become outdated, many things done the old-fashioned way can still work today.  Our ability to save for the things we want is one of those things.  Rather than save, many now resort to the use of “credit.”  The secret to avoid the debt trap is to start doing things the “old-fashioned” way. Although having a mortgage against a home is acceptable for the purpose of owning a home, continually using home equity for vehicle purchases or credit card consolidation is not.  Choose your debt carefully.  Doing things the old-fashioned way may not be such a bad idea.   

The Credit Counselling Society provides a list to alert people to the typical warning signs of debt that might be out of control. Click here to check their list.         

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