Your Simple Financial Plan, Part 4 – Get Rid of the Debt Handcuffs
For several years, this message has been blaring loud and clear from the media, the government and financial experts. So what’s the problem? Why aren’t we listening?
I’m continually surprised by how much it takes to live, especially in a major city like Toronto. You need an above average salary just to pay for the basics like food, shelter, transportation and kids. One of the biggest issues is affordable housing. Yes, everyone deserves to own their own home, but the reality is that many will not achieve that goal. There is nothing wrong with renting for life. The sooner we all accept that, the better.
Many people believe that owning a home is the path to wealth creation. It can be, but by no means, is it risk free or the only path to take. You always need a place to live so it may be tough to convert your home equity down the road into income for retirement. In fact, last May, the Financial Post reported that over the long term (10 & 20 year periods ending 2012) investing in stocks has outperformed real estate (and bonds, GIC’s). Don’t get me wrong- I am a believer in owning your own home. But only if it’s something you REALLY WANT and CAN AFFORD.
It’s time for all of us to get real and make choices. To make a significant dent in your debt, you need to either increase income, reduce spending or both. Use your creativity and come up with some new or interesting ideas. Especially while interest rates remain low.
For anyone concerned with their level of debt, I have a suggestion. A great exercise is to play with some debt scenarios using an on-line calculator. They might open your eyes to new ideas. Like saving more before you jump into debt. Or they might give you the motivation you need to accelerate repayment.
Here’s an example, using the mortgage calculator on the website GetSmarterAboutMoney.ca
Let’s say that you have a $300,000 mortgage at 4% interest for a 25 year amortization period. Probably not unlike many young families today.
How Much Does Your Debt Really Cost?
Here’s what your total debt (principal + interest) will cost you over the life of your mortgage under the following scenarios:
1) $473,418- if you pay it off monthly
2) $435,057- if you pay it off monthly over 20 years instead of 25
3) $523,444- if you pay it off monthly, but your interest rate rises to 5% from 4%
In other words, you will save over $38,000 by paying off your debt 5 years sooner. That’s a lot of money! Or, if your interest rate rises by a meagre 1%, you will pay an extra $50,000 over the life of your mortgage!
You can play with many scenarios to see the impact and determine what’s best for you. It’s often shocking to see how small changes in interest rates, payment frequency or extra payments can make a big difference to your overall cost. These basic principles apply to any type of debt i.e. credit card debt, lines of credit, even car loans. Do yourself a favour and take the time you need to understand debt. The faster you eliminate it, the faster you can make your money work for you. Once you get rid of debt, you can redirect money towards investments that will grow in value and/or pay you income. This will make YOU richer, not someone else!
Whether you’re in over your head today or considering new debt, you owe it to yourself to understand what it means for your life. Then, whatever your decision, you will feel good that you’ve done some homework. Incurring debt (for assets that increase in value) can be the right thing to do – but only if you go in with your eyes wide open.
Photo credit- moneycrashers.com