With Canadian household debt staggering at 170% of annual income, it is clear that accessible consumer credit (i.e. credit cards, line of credits, student loans, short term loans, pay day loans, etc.) is being abused. Banks and credit card companies facilitate their only credit and risk assessment; however, to determine whether or not an individual truly needs such credit is entirely the individual’s discretion.
The approval process of credit (by the bank or lending company) is mostly to assess your ability to service the interest payments on the loan, as well as eventually making the principal payments to eliminate the debt. Lenders review an applicant’s net worth (calculating the difference between assets and liabilities or things owned vs. amounts owed), annual earnings, and credit history. There is a science behind their analysis, such approval methods have been mastered over the years to protect the lenders (not so much the applicant); therefore, it may not be in the best interest of the individual to accept credit that has been approved.
The Problem with Consumer Debt
First it is important to define consumer credit:
A line of credit extended for personal or household use.
Consumer credit could be used to purchase anything (mostly disposable goods and entertainment), unlike a mortgage or car loan which is attached to a physical asset. Therefore, the consumer might be at risk if they do not have available cash to service the debt, compared to secured loans (in most cases), the lender could collect the asset if an individual fails to make payments.
The following is a list of questions and concerns every individual should address before applying for consumer credit:
- Is the credit actually needed?
- Is there enough room in the budget to accommodate a set loan payment?
- Could the credit card balance be paid off every month?
- Do you know how much interest you will pay over the life of each transaction by using the consumer credit?
- Would you be willing to sell your possessions if you are not able to make the minimum payments?
- Are you aware of the long term consequences if you are unable to meet your obligations to servicing the debt incurred?
- Would your purchases generate a higher rate of return than the amount charged in interest?
- If you lost your job tomorrow could you pay off the balance of your debt with your current savings?
Even if the answer was ‘Yes’ to all of the questions, consumer credit in the grand scheme of things is not for everyone. Even the most financially savy individual should be cautious when using consumer credit. Currently there are software packages and smartphone apps to track your spending (including credit card transactions); however, the process of reviewing past purchases does not effectively help you eliminate your debt. More importantly it takes away from your ability to generate wealth.
Consumer credit is too expensive, especially if you do not have the money to pay off the balance over a short period of time. The convenience of these products causes many individuals to overlook the true cost of purchasing goods on credit. Even if you are contributing to savings, having a credit balance acts as negative savings thus it is more economical to pay off your consumer debts before allocating funds to savings.
A great benchmark is to dedicate 20% of your take home pay to first service consumer debt and then savings.
For your convenience, Student Destinations has created a Debt Elimination Calculator to help create a payment plan that complements your monthly budget.
The calculator provided on the site is only for illustrative purposes to give a general idea how much or how long it will take to pay off individual debts. For detail planning purposes we have created a workbook for your convenience to schedule your debt repayment in the most cost efficient way. By clicking on the icon below, the ‘Debt Elimination Workbook’ will download automatically:
Assessing the need for Student Loans should be treated with the same caution as consumer debt, as it is consumer debt. There are no guarantees that the program an individual enrols into will justify the monthly payments after graduation. Although it may appear time consuming, many Canadians are now deciding to postpone higher education until they are able to afford to go. The benefits of postponing could potentially outweigh the opportunity cost of enrolling right after high school.