Every time I see the, “You’re richer than you think” ad I get mad, because it’s a blatant misstatement of the financial situation of the average Canadian with $28,000 in consumer debt. It’s ironic that, right after the Christmas spending binge, the financial services industry launches ads telling us we’re richer than we think, and we need to take on more debt.
They know exactly what we owe, then try to convince us to take out RRSP loans, buy their investment products to get more of our money, while they reap huge profits in the process.
The bank commented: “Canadians are more comfortable with how they are managing their debt.” Banking industry-speak for “managing debt” means servicing debt, which means earning enough income to make the required regular payments.
Servicing debt doesn’t necessarily mean paying down debt, or using strategies to pay down more of the principal. A significant amount of consumer debt is in credit cards, with interest rates in the high teens. Your credit card company loves this!
The finance industry can relax as long as consumers’ earnings keep a shade ahead of their regular debt payments. They’re rooting for us all to earn more and spend more to fuel an economy that relies all too heavily on consumerism.
Governments and businesses get nervous when the household debt to income ratio rises. According to Statistics Canada we owe a record $1.64 of debt for every $1 earned each year. The income/debt treadmill can only generate bigger profits if household earnings keep pace with debt. If the cost of servicing debt grows faster (rising interest rates), it breaks down.
Debt to income ratio means little to individual households. For example, a young family with a modest income and a mortgage could get by owing $3 for every dollar earned to invest in a home. Mortgages interest rates are relatively low, and household incomes usually rise over time while the mortgage balance drops, lowering the debt to income ratio. Eventually, higher incomes mean more money to pay down debt and save at the same time. Higher incomes also means higher tax brackets, translating to bigger tax savings on RRSP contributions.
Interest on RRSP loans are not tax deductible so they should only be used if you are in a high tax bracket. Contributing to an RRSP during low income years is pointless, if you will be withdrawing in the same tax bracket in retirement. The only advantage is that your savings grow faster when free of tax, but CRA will eventually take a bigger percentage of your retirement nest egg when withdrawn.
In any case, there are few if any investments that can guarantee a tax-free return equal to the amount of interest you will save by paying down high interest debt. For example, taking out a line of credit at 4% to pay down a credit card balance at 18% instantly saves you 14% in interest expense.
The catch 22 today is, low interest rates are encouraging consumers to load up on debt. I worry what will happen if interest rates go back to more normal levels, sooner rather than later.
I encourage anyone with high interest debt to pay it down as quickly as possible. If you’re unsure how to get started, work with a financial advisor to set up a budget, and explore debt consolidation opportunities.
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