Choose Your Debt Wisely

 

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.         

Borrowing Money Is Like Jumping Hurdles

 

 

Imagine yourself seated across the desk from a loans officer, waiting anxiously to hear the verdict.  Will your request for a loan be approved?  Initially, you felt confident and now you have doubts.  What exactly is the loan officer analyzing?

The credit process can be likened to jumping over hurdles.  As you jump through the following points, you get a sense of the criteria the loans officer puts under the microscope to analyze whether you qualify.  

Hurdle #1: Your Credit Report.  Your credit report will be your first means of defense.  If you have always consciously made your payments in a timely manner, meeting all your loan obligations, then you should have no concerns.  Quite often, people don’t realize what’s involved in maintaining a healthy credit report.  To ensure you understand your credit report and credit score, click here for additional information from Financial Consumer Agency of Canada.  If your credit score is low, you can improve this by implementing some sound strategies as shared in the previous blog, Protect your Score.

Hurdle #2.  Capacity to Make Payments. You can be assured your income plays a significant factor in determining whether or not your loan is approved. Capacity is measured by using ratios: Gross Debt Servicing (GDS) and Total Debt Servicing (TDS).  These are math calculations to ensure your debt payments don’t interfere with your ability to manage day-to-day living expenses.   

GDS focuses on your ability to meet shelter costs, rent or mortgage payments.  That’s all it does.  Generally, when applying for a mortgage, this ratio is used to measure your ability to manage payments.  The amounts factored into the calculation are: mortgage payment (including principal and interest), property taxes, and heating costs.  If the mortgage is for the purchase of a condo, then 50% of the condominium fees are also included.  Once these amounts are tallied, the total is divided by your gross income and then multiplied by 100 to determine your ratio.  Keep your fingers crossed! The guidelines are 25% to 30% of gross income. (Sometimes 32% is acceptable.) The lower the ratio the better since this indicator measures the percentage of your gross income required to cover shelter payment.  For example, if your ratio is 15%, then only 15% of your total gross income is funding your mortgage/rent payments. 

The formula for calculating GDS is as follows (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable) GDSR =                    -----------------------------------------------------------------------------                                              Gross Income

 

TDS calculates your ability to manage all debt obligations including child and spousal support payments.  For many, the big surprise is the payment amount for credit cards is calculated on the available credit limit, not the outstanding balance.  You may have an outstanding balance of $5,000 but your MasterCard credit limit is $15,000.  Your payment used in the calculations will be $450 (3% of $15,000) since you have access to this credit at any given time.   Because you haven’t used the entire balance today, doesn’t mean you won’t tomorrow.  So lenders realize that if you do, then monthly minimal payments will increase.  Although having access to a high credit limit may be beneficial, the full payment affects your TDS ratio as well as the credit limit is the amount shown as a liability on your Net Worth Statement.  

Since you are aware of the amounts involved in the TDS calculation, tally the total, divide by your gross income, and multiply by 100 to determine the ratio.  Ideally your TDS should be 35% or less.  Some institutions allow a ratio of 40%.  Although your loan may be approved despite your high ratio, you have to consider the financial situation in which you may place yourself.

Here’s a glance at the formula for calculating TDS (calculate either monthly or annually):

 

Payment of principal and interest on mortgage                                              + property taxes                                              + heating costs                                              + 50% of condominium fees (if applicable)                                              + payments on other personal loans TDSR =                   -----------------------------------------------------------------------------                                              Gross Income

 

Hurdle #3: Your Net Worth (Capital).  Another measurement of creditworthiness is your present net worth. When assigning a value to assets such as motor vehicles, snow machines and the like, use realistic values. Do not overvalue them. Vehicles are a perfect example since they quickly depreciate. In reality, question whether someone would be willing to pay this amount for a particular asset. 

To help create your Net Worth Statement, click here to use this on-line calculator. Once your statement is created, liabilities are subtracted from assets. If your liabilities are greater, then your negative net worth is alerting your loans officer to a potential problem.  Generally, the one exception for showing a negative net worth is if a student acquires debt in pursuit of an education. Technically, as a student, you are an asset with the ability to generate an income to pay off your student loans. 

 

Assets Everything You Own	Liabilities Everything You Owe
Net Worth (Assets – Liabilities)

 

 

Hurdle #4: You (and Your Character).  It’s about you.  Attitude is everything.  Attitude shows up in your credit report, your ability to be employed, and in your conversation with your loans officer.   The important question to answer is: Will you uphold your promise to repay the loan? As time goes on, you accumulate a history which will follow you.  Establishing a strong relationship with your loans officer will be important.  Over time, you, no doubt, may require more than just one loan. 

 

Hurdle #5:  Collateral.   The reasoning behind using collateral to secure a loan is assurance that some or all of the money can be retrieved if you happen to default on your loan.  So many unforeseen events might occur to cause you to miss payments and neglect your financial obligations. Eventually, the only recourse remaining for the lender is to sell your asset to repay the loan.  Whether you assign your car, investments, or house, as collateral, you pledge a promise to pay back the debt. In the event you don’t, then the asset will no longer be yours.  When examining all the criteria to approve your loan, collateral generally would be the last consideration.

 

How does everything look as you jumped over the hurdles?  This information cracked open the door to the credit assessment process. Everyone’s borrowing needs are different; special consideration is given to special circumstances.  Guidelines are in place as tools to help with the process.  Not only are the financial reports and ratios analyzed but your loans officer also implements good judgment on your behalf.  When you continue to meet your loan obligations consistently over time, you will build both a trusting relationship with your lender and a strong credit history.  This best outcome when borrowing money becomes necessary to fulfill your dreams.