Dealing with Debt
Debt is not a fun topic. Well, maybe it is if you like engaging in stories like those of the Four Yorkshiremen, later popularized by Monty Python, who sought to outdo each other with their personal histories of poverty.
Poverty and debt are not, of course, strictly identical, but the latter can certainly lead to the former.
Debt Classifications
First, some definitions. In broad terms, debt can be classified as follows.
Secured Debt
As the name implies, debt of this sort is “secured” against default by the borrower pledging an asset. A typical example might be a car loan. Cars, and especially pickup trucks and SUVs, are expensive depreciating products and are probably among the most common reasons why people get into this form of debt.
Probably less common is the non-registered margin account at an investment firm. In this case, you are borrowing against your existing investments to invest more. This is also a kind of secured debt. When I worked at a discount brokerage, the Great Financial Crisis of 2008-2009 was when I spent a fair bit of time calling out to active traders telling them that unless they deposited new money or sold an existing position, our margin team was going to sell them out.
Unsecured Debt
In this type of debt, nothing is pledged as collateral. Instead, lenders gauge their willingness to allow you to borrow money by doing a credit check. One example of unsecured debt is a student loan. You may be interested to know that, depending on your program, you may be able to borrow more money. While graduate studies in an arts or science program may be limited to $80,000, a dental or medical student may be able to borrow up to $350,000, on the assumption that a future physician or dentist has more earning potential than a future historian or botanist.
Revolving Debt
The classic example here is the credit card. This type of debt is revolving in the sense that it can be used to borrow money for almost anything and can continue to be used as long as you meet the minimum payments and do not exceed the credit limit attached to the instrument. A typical credit card will likely charge 19.99% interest. The enticement, though, is that your statement will often advise you that you can pay as little as $10 per month. Succumbing to that offer, though, can get you into trouble as the debt payments can go on for years and cost you a lot of interest in the meantime.
Credit cards can be both secured and unsecured. Secured credit cards may be required if you are a newly arrived immigrant without a credit history or if your credit history has been badly damaged. Typically, you would leave a deposit at the financial institution equal to the credit limit on the secured credit card.
Mortgage Debt
Technically, mortgage debt is a type of secured debt in that the home you buy secures the money borrowed, but many rules around mortgages distinguish them from car loans, for example. With interest rates currently rising after many years of going down, there is much discussion about whether to choose a fixed rate or a variable rate mortgage. Among the many curious rules in this space is that fixed-rate mortgages in Canada are compounded semi-annually, while variable-rate mortgages are usually compounded monthly.
Credit Card Spending
Certainly, the cost of housing went up during the pandemic, but one of the outcomes of COVID-19 was that many people benefited from government programs to put money in people’s pockets. While those benefits did not always allow businesses to survive, the lack of spending opportunities allowed the average Canadian household to build up substantially more savings than they were doing pre-pandemic. Growing investment accounts and home values also added to that sense of wealth for many. As a consequence, in the first few months of this year, Canadians exercised their spending power in ways they had not been able to for the previous two years. On average credit card use increased 17.5% during the first quarter of 2022 compared to the first quarter of last year.
However, as inflation appears to be ramping up, that increased spending, especially on discretionary or nice-to-have products and services, may have to be restrained. If you are wondering who is responsible for most of this extra spending, according to the credit rating agency Equifax, Ontario is the province with the most increased credit card spending at 20.4%, with Quebec close behind at 18.4%. As for generational differences, millennials (born 1980-1996) and Gen Z (born 1997-2011) were the biggest spenders. The millennials’ spending is not surprising as they are the generation that are forming households, buying homes, and having children, when spending is typically at its highest.
What Happens to My RRSP if I go Bankrupt?
Even when people don’t have much money, they may still go to a bank to borrow money and make an RRSP contribution on or around March 1 every year. That tax deduction is beloved by many. But what happens when borrowing is a bigger problem? If it gets to the point where you are contemplating bankruptcy you may wonder what will happen to your RRSP. There is some reasonably good news here. At the federal level, RRSPs were made much more like registered pension plans thanks to updated legislation in 2009, meaning there is substantial protection for your RRSP against your creditors. This protection also extends to Registered Retirement Income Funds (RRIFs), Registered Disability Savings Plans (RDSPs), and Deferred Profit-Sharing Plans (DPSPs).
Don’t think, though, that you can borrow to fund your RRSP and then file for bankruptcy a few months later. In most cases, a contribution made to an RRSP within the year before declaring bankruptcy will be excluded from protection. Your contributions over the previous five years may also be investigated if you were anticipating bankruptcy in that period.
As might be expected, treatment of RRSPs varies by province. If you are in Alberta, your accounts are fully protected. In other provinces, the rules become somewhat more complicated.
One of those complications is the investment product. If you go to your local bank or credit union branch, open an RRSP, and buy some mutual funds, your protection may be less than full. If, however, you go to an insurance agent and buy segregated funds for your RRSP and then name an irrevocable beneficiary such as your spouse or common-law partner, then your assets are generally protected from creditors and bankruptcy claims. If you are in a career in which creditor actions in court or insolvency have a higher probability than for the average person, you may wish to use segregated funds despite the higher fees.
Debt and Economic Impact: Debt-Free does not mean Scot-Free
If your home is mortgage-free, your car was bought without a loan, neither you nor your adult children owe any money from students, and your credit cards are paid off in full every month, you may think that nothing can touch you. That may be close to true, but it is certainly not completely the case.
Canadians do not live in isolated households. We are part of larger communities. Those around us, even those on the other side of the world, have an impact. Consider the war against Ukraine being waged by the Russians. Ukraine is a major exporter of grain to many parts of the world. This war reduces Ukraine’s ability to supply wheat to its usual customers, driving up the cost of food.
Then there is the microchip shortage, which among other things, is leading to a shortage of new cars and driving up the price of used cars. I could go on.
Consider the indebtedness of many Canadian households. Even though a mortgage may be considered a kind of good debt in that over the long run, the property should appreciate, multiple hundreds of thousands of dollars owed on a new home is no small matter. This is especially so when inflation is heading higher leaving you with even less leeway. At the beginning of this year, I noticed that houses were being snapped up almost immediately after being listed. Now, many are languishing and even coming off the market. Combine that with declines in the investment markets and there may be a general mood of feeling less wealthy.
If people are increasingly feeling less confident about their financial futures, they start to cut back on everything. Vacations become staycations. Visits to restaurants become backyard barbecues. Home maintenance is put off for another year.
Now, multiply this scenario over and over again. Even if debt is not your problem, the fact that it is a problem for many Canadians means it will have an impact on everyone’s lives and could lead to a recession or exacerbate a recession that is perhaps already on its way. It is in everyone’s interests, even those who are debt-free, to create an environment where those in debt can reduce the amounts owing to supportable levels.
Dealing with Debt
Get Specific
In an article published in Advisor’s Edge, author Daniel Calabretta raises the unpleasant topic of debt. Taking some lessons from licensed insolvency trustee Doug Hoyes, one of the most important things to do is to get “very specific” about debt and cash flow. While not all who owe money will need to pursue a consumer proposal or personal bankruptcy, we should all have a clear idea of our debts.
This may sound like an exercise in pain, but one of the most important elements of the financial planning process is understanding your cash flow, that is, money coming in and money going out. As Charles Dickens wrote in David Copperfield, “Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.”
Budgeting?
I am not a huge fan of budgeting. However, I do encourage – and I do this myself – tracking of income and expenses. It doesn’t need to go by some fancy accounting term like Cash Flow Statement, but that is essentially what you are doing. Once you have that in place, it is a relatively easy step to identify those expenses that are pushing you into debt.
Automating Bill Payments
I like this approach, but it is a bit of a two-edged sword. If you are trying to get debt under control, the review of your expenses may lead to discoveries of all kinds of bills that are paid automatically that had fallen off your radar. Major communications companies will offer bundles that may include cellphone, internet, TV, and home monitoring. Are you using those services? Gym memberships are probably a classic. Are you going to the gym frequently enough to make it worthwhile to you? Assuming you have identified some regular charges against your bank account or credit card that you are not benefiting from, you can take the next step to cancel those services and start saving money.
The positive side of automating your bill payments is that you don’t have to worry about missing payments and getting in trouble with the service provider. Given that credit cards generally charge higher levels of interest than any other source of borrowing, the ability to automate those payments is probably among the most important and valuable to you.
That doesn’t mean that we must never go into debt. Borrowing can have useful purposes if adding the expenses of debt repayment to your cash flow analysis still leaves you on the happiness side of that Dickensian equation. It’s all about living within your means, or perhaps even better, living beneath your means so that you can set aside money for future spending, including spending for emergencies and in retirement.
This is the 152nd blog post for Russ Writes, first published on 2022-06-13.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.
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