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Too much debt, too little planning

Monday, January 17, 2011

Major credit and debt problems in the United States threw most of the developed world into a deep recession in 2008-09. Huge debt loads at the personal, state, and federal levels in the U.S. have since kept that country from achieving a full economic recovery and may keep its economy underperforming for the next decade or longer.

The greenback has struggled, and the U.S. has avoided more serious problems by printing more and more money to keep things moving. They can do this only because the U.S. dollar is the reserve currency for the world. It is used in almost every oil purchase and is held by most governments in reserve. The fact that the U.S. economy has been injected with the biggest fiscal stimulus package in history and still has not fully recovered gives you an idea of how big the problem really is. It is large enough to remove America as the “economy that moved the world.”

The Canadian connection

Many people will ask how the U.S. debt and related economic problems affect Canada, which for the most part came through the recession much better than our southern neighbors. In its Dec. 14, 2010, issue, The Vancouver Sun pointed out, “Canadian household debt as a percentage of disposable income is now higher than the US levels for the first time since 1998.” That’s a scary thought.

Whatever you may have planned for the future, it will be more difficult to achieve with higher debt. Being aware of debt and making it a fiscal priority to reduce debt over time is a cornerstone in the financial planning process.

By some estimates, Canadians are retiring with more debt now than ever before. That is another red flag. When a couple is moving towards retirement, getting that mortgage and other debt paid off is just as critical as saving money in pensions, RRSPs, non-registered savings, and TFSAs. Going into retirement with no debt helps you in many ways. There’s less stress in retirement (if interest rates rise), you are able to live on less capital, and you are less dependent on stock markets, because you you can live more cheaply.

With North American debt at very high levels, what happens if interest rates rise? Higher debt-servicing costs and a slower economy as a result of consumers’ reduced purchasing power. Your standard of living will also decrease unless you also have corresponding increases in salary to offset higher debt-servicing costs. We have had historically low interest rates for quite some time. It’s worth noting that nothing lasts forever. Low interest rates won’t either. In the short to mid-term, rates need to stay low to help the anemic U.S. economic recovery to continue.

Consumption, credit and debt

Our developed economy is very good (maybe too good) at getting credit in the hands of consumers who aren’t afraid to use it. Many credit card companies bump up your credit limit (often without informing you) after you achieve a decent payment history with the company. That is a very dangerous practice (for consumers). Before you know it, you have $20,000 or $30,000 credit available.

The credit card companies make the most money from people who don’t pay the full amount every month. They like clients who pay the minimum, because they make a fortune off you in interest charges. If you can’t pay the full amount off in most months, it is a signal that you are living above your means. This can and will catch up with you. I contacted my credit card providers and requested that they don’t increase my credit without my written instructions.

At least once a year everybody needs to do a quick net worth calculation. Add all assets, like your home/condo/vacation property, RRSPs, and investments, and subtract mortgage loans, lines of credit, credit card debt, car loans, and any other debt. That gives you an idea of your net worth.

Under normal circumstances, your net worth should grow. If markets drop 30% to 40% as they did in 2008, growth in your net worth is likely to stall, but situations like that are an anomaly and beyond your control. Even if your net worth is increasing over time, your liabilities (debt) should decrease. You don’t want a big mortgage heading into retirement, because that will surely curtail your retirement lifestyle unless you have very high cash flow.

When are we fiscally on track?

We are bombarded by offers and advertising on a daily basis, but buying too much of what we want as opposed to what we need can get us into serious trouble, even if we’re paying everything off each month. I think you are on track when the following items are taken care of:

• Your net worth is rising over time.
• Your overall debt is decreasing over time.
• You are investing regularly in RRSPs (to reduce taxes and save for retirement), especially if you don’t have a defined benefit pension plan.
• You also invest in TFSAs, non-registered accounts, and RESPs to take advantage of government programs to save tax or receive grant money for education
• You have adequate life and disability insurance.
• You have some short-term savings (in case of job loss, to pay for holidays, emergencies, etc.).
• You have wills in order.

My dad always says “stress is a killer.” Well, debt can be a killer too. Not in the same way as my dad meant, but it can be a killer of dreams and plans. If you play too much today and accumulate too much “stuff,” instead of putting away 5% to 10% to “pay yourself first,” you’ll probably be forced to work long into retirement. And that’s the real consequence of too much debt and too little planning.



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