We don’t know exactly when but at some point in time interest rates will rise again as central bankers attempt to curb inflation somewhere down the road. Now might be a fantastic opportunity to review your debt status and make sure you are not caught with your proverbial pants down. There are a few things you can do to analyze your debt status.
Good Debt vs Bad Debt
What is your ratio between your good and bad debt? Generally the definition of good debt is debt that has been incurred to purchase an appreciating asset like real estate or to provide funding for education as this is an investment in oneself that will pay off someday. Bad debt is defined as debt incurred by purchasing assets that do not appreciate like cars or credit card debt for non-appreciating purchases.
Interest rates
Review the rates of interest that you pay on your different levels of your debt. Clearly if you have different levels of interest rates serving your debt levels, you probably have a good opportunity to implement a debt consolidation strategy, rolling some of the higher rate debt to the lower rate debt.
Debt-to-income ratio
One vital step in the debt review process is to calculate your debt-to-income ratio. This is done by simply dividing the amount of debt you service each month by your gross income. For example if you contribute $2,000 per month towards debt payments and you earn $5,000 per month then your debt-to-income ratio is 40 per cent. Generally speaking if your ratio is 36 per cent or less then you should not stress, I know it rhymes. However if this ratio is between 37 and 42 per cent then you should probably start paring it down. If your ratio is higher, you probably need to take immediate action. Above 50 per cent, you should seek professional help to aggressively reduce your debt.
Treat debt as an investment
So what do I mean by this? Sometimes paying down debt can be one of the most effective investments you can make. It astounds me how often I see folks with a GIC investment paying three per cent before tax but yet they have debt at three per cent after tax.
The point here is that when you make a capital payment to your debt you are making a guaranteed, tax free return of three per cent as per the example above. The reason for this is that you get your three per cent back tax free from the lender if you pay down your debt. When you have both extra cash to invest and outstanding debt you should always consider your debt as a potential target for this cash.
Don’t pay your bank interest on money you don’t owe them
This comes about when you have cash sitting in a cheque or savings account and you have a debit balance on a credit card or loan with your bank. Effectively, if you look at your balance sheet with the bank you are paying them interest on money you don’t owe them, good time to restructure your bank balance sheet by moving some of that dormant cash to the reduce the debt balance.
Remember to always consult your advisor before taking any action.
Stuart Kirk is an Investment Funds Advisor with Manulife Securities Investment Services Inc and a Retirement Planning Specialist with Precision Wealth Management Inc. The opinions expressed are those of the author and may not necessarily reflect those of Manulife Securities Investment Services Inc or Precision Wealth Management Inc. For comments or questions Stuart can be reached at stuart@precisionwealth.ca or 250-954-0247.
