Canadian households are more indebted than they have ever been, but with some simple steps they could do a better job of managing their debt, lowering their interest payments and making more money available for other uses, says Alex Lucas, Assistant Vice-President, Product and Marketing, Manulife Bank & Trust.
Q: What is a key to managing debt?
Alex: Creating and sticking to a budget. It's one of the simpler parts of financial planning but even if people do create a family budget, they often don't check to ensure that they're actually spending within the limits they've set for themselves. Whether your immediate goal is to reduce your debt, save for retirement, save for education or buy a car, the key is spending within your means. There are going to be months where expenses are much higher and you need to know how you are going to cover those expenses. If it is by borrowing, you have to have the cash flow to pay down that debt after the unexpected expense.
Q: How can people tell if they have too much debt?
Alex: There's not a specific percentage. You can look at how much of your total income is taken up by debt payments and if that seems high to you that's one indication. You can also check what would happen to your mortgage or debt payment if interest rates were to increase by a significant amount. If you couldn't absorb those payment increases, that would be a sign you're carrying too much debt.
Q: How much of a percentage rise should you have a cushion for?
Alex: It depends on your individual situation. You should talk to your financial advisor about a few different scenarios and what the impact to your finances is of interest rate increases. Interest rate predictions are very difficult to do over a long period of time. You want to focus on how much interest rates might change in a two- to five-year period.
Q: What should people do to reduce their debt?
Alex: Make sure you know where you're spending your money and see how much money you can allocate to other financial goals. Find out where your money is going and allocate what you can to debt. Canadians tend to carry anywhere from three to five different credit products. Often there's an opportunity to consolidate some or all of those into something that's more efficient or at a lower rate. We're big proponents of setting a debt-reduction goal and tracking it the same way you'd set a target for retirement savings. Check after six to twelve months to see if you're on track to hit your goal. People should also speak to a financial advisor to incorporate their debt-reduction goal into their broader financial plan.
Q: What's a good definition of living within your means today?
Alex: It comes back to setting that budget. A budget will help you understand what payments you need to make to reduce your debt, what contributions you need to make to your investments, what you need to cover all your expenses and, finally, how much discretionary spending is available to you. And work within that amount. If you're looking for more discretionary spending, ask a financial professional to look at the types of debt you carry and see if you can reduce your debt expense by consolidating that debt at a lower rate. Without a budget you don't have any context to know if you'll be able to meet your debt-reduction goal.
Q: How deeply in debt are Canadians?
Alex: We have the highest debt-to-income ratio on record, for as long as we've been tracking this through Statistics Canada. On average, we have $147 of debt for every $100 of disposable income. However, individual circumstances vary and not all debt is bad. It's important that Canadians start discussing their level of debt with their financial advisor and what is optimal to meet their financial goals.
Q: How precarious a situation are Canadian families in?
Alex: It varies widely from household to household. In a lot of cases that debt is applied to productive uses like their house and education for their kids. The major risk is economic events we don't anticipate that cause really high interest rates, in particular for a younger family that has taken on the maximum debt for which they qualify. They're going to be stuck with these large inflexible payments. New homeowners may also have unexpected expenses and that's when people end up having to dip into credit cards or other types of debt, which are sub-optimal because of the interest rate. It creates, for a family, quite a bit of cash-flow stress and pressure, either to cover those unexpected expenses or to contribute to other financial goals.
Q: Where should people go to avoid, manage or reduce debt?
Alex: This is part of the core problem. People just aren't talking to anyone about debt. You look at the 40-somethings and 63 percent of them aren't talking about debt to anyone, yet a significant portion of them carry a lot of debt. We think the industry can increase the focus on planning to reduce debt, and we believe independent financial advisors may be in the best position to do this.
Q: What is an independent financial advisor?
Alex: Advisors who are not employees of a product provider; they're free to offer financial products from a variety of providers. And because they're not required to sell the products of any particular organization, they'll gravitate toward what they feel is the best solution available on the marketplace for a client, as opposed to being tied to a limited product shelf.
Q: What happens to people who don't manage debt properly?
Alex: They're not able to reach their other financial goals, or not in the time frame they're looking for. The main impact of carrying too much debt is strain on your cash flow.