Debt is relatively common in life. In 2019, 73.2% of Canadians had outstanding debt or used a payday loan. And if you feel like your debt is too high, you're not alone – 31% of Canadians believed they had too much debt.1
Debt consolidation is a strategy you use when deciding to get yourself debt free. It combines and merges all the debt you owe into a single, monthly, recurring payment with a fixed interest rate. There are two steps to complete before considering debt consolidation as a method of repaying your debts.
First - Identify your debts: Good vs. Bad Debts.
Good debt is considered debt that's on assets. Mortgages and lines of credit fall under good debt. Car loans, credit card balances, payday loans, taxes you owe, and unpaid utility bills are considered bad debts.
Before meeting with a financial advisor about your debt, you will want to know the total amount you owe, the minimum monthly payment, and the interest rate of both good and bad debts.
Second - Review your budget.
Reviewing your budget will help you determine how much money you earn, spend, and save by balancing your income with regular expenses. It will provide direction towards how you can reach your financial goals.
Once you have identified your debts and reviewed your budget, you can consider if debt consolidation is beneficial.
When to consider debt consolidation?
Debt consolidation is a good idea when:
-
You have excellent credit, qualifying you for a lower-interest debt consolidation loan.
-
You have large amounts of high-interest debt.
-
You're ready to change your financial habits to avoid further debt.
When not to consider debt consolidation?
Debt consolidation may not be for you when:
-
Your spending habits are the same as when you got into debt.
-
You can repay your debt in less than a year.
-
You're already trying to improve your credit score.
Debt consolidation can help you if you've taken steps to assess your financial picture and plan for a different future. Those not ready to change their financial habits can find themselves in more debt after freeing up their credit cards.
Debt Consolidation Requirements
There are specific requirements to determine your eligibility for debt consolidation. Listed requirements vary between lenders, and particular lenders may have less stringent requirements than others. Standard requirements typically include:
-
Reasonable low-risk credit history and credit score.
-
Proof of income.
-
Proof of collateral for large loans.
-
A low debt-to-income ratio.
Your debt-to-income ratio is calculated by assessing your existing monthly debt payments divided by your monthly income.
What's the best type of debt to consolidate?
You can consolidate any debt, but certain types are better suited for debt consolidation, such as unsecured debt, due to their higher interest rates and monthly payments. Unsecured debts include car loans, credit card balances, payday loans, taxes you owe, and unpaid utility bills. Out of all these, credit card debt is typically the best to consolidate due to the high-interest rates they carry.
What type of debt consolidation loan is most common?
A Home Equity Line of Credit is one of the most common loan options for debt consolidation as it typically offers a lower interest rate than other types. It can be used by homeowners who have built up home equity by making monthly mortgage payments or owning the home outright. The loan is considered secured since it uses your home, a physical asset, as collateral.
How does it work?
Let's say you have $25,000 in three different debts totalling $75,000 of debt. Each debt vehicle has a different interest rate with three different annual payment values paid to separate sources.
Your Home Equity Line of Credit has an interest rate of 2.95%, resulting in an annual interest payment of $737.5. Your unsecured line of credit has an interest rate of 8%, equaling an annual interest payment of $2,000. And finally, your Credit Card has an interest rate of 20%, resulting in an annual interest payment of $5,000. These three payments would result in an annual interest payment of $7,737.5 without debt consolidation.
If you were to consolidate all three by taking out an additional $50,000 on your Home Equity Line of Credit to pay off the other two debts, you would pay $2,212.5 in interest annually. You are saving $5,525 each year in interest payments with debt consolidation.
Investment Loan
An alternative way to pay down debt many people don't know about requires a financial advisor to help you execute. Investors who hold income-generating investments such as publicly traded stocks that pay dividends or mutual funds that pay distributions, such as Matco's mutual funds
can use an investment loan to lower annual interest payments.
What is an investment loan?
An investment loan is when you use your income-generating investment holdings to pay off debt. Investment loans can only be used with a non-registered investment account, which does not include Tax-Free Savings Accounts and RRSPs.
How does it work?
Let's say you have $100,000 in a non-registered investment account and $100,000 of debt on a line of credit. Depending on capital gains in the investment account, you can sell the investment account holdings. You then use the $100,000 cash to pay off your line of credit. Once you have paid off the line of credit, you take out a $100,000 investment loan to repurchase the investments. Your interest payments are lower with an investment loan since you can generally claim the investment loan interest payments on your taxes.
When to consider an investment loan?
Investment loans are not suitable for everyone as it requires you to have enough income to make loan payments and stay invested for more than 10 years. Talking with your financial advisor about whether an investment loan is right for you is crucial. If so, it can be an excellent tool for helping you lower your annual interest payments.
What can you start doing today to eliminate debt?
The two general rules of thumb that you can do on your own are:
-
Focus on reducing your credit card debt. The high-interest rates can impact your ability to get out of debt. Start by planning a budget and allocating monthly money to pay down your credit card balance.
-
Work on the rule of 4%. If the interest rate is above 4%, you should question paying it off before saving more in a portfolio.
The Bottom Line
Everyone's debt is unique to them. Book a short talk with me, and I'll provide you with a personalized plan on how you can get more from your debt.
Tom Stachiw, CIM
Portfolio Manager
Local: +1-403-718-7792
Footnotes:
1Source: Government of Canada website Canadians and their Money: Key Findings from the 2019 Canadian Financial Capability Survey
MATCO FINANCIAL INC.
Founded in 2006 to manage and service seven family offices, today Matco offers the benefits of our extensive investment management experience to individual investors, foundations, endowments, condominium corporations, trusts, corporations and not-for-profit organizations.
Our mission is to simplify the investment world for our clients by understanding their needs and providing exceptional investment solutions that preserve and grow capital.