The True Cost of Debt

By Doug Hoyes

Everyone knows that they have to pay interest when they take out a loan. It’s the price we pay to use someone else’s money to purchase something we don’t have the cash for today. But beyond that, it’s hard to comprehend just how expensive debt can be.

Generally speaking, we don’t really consider the long-term financial impact of taking out a loan, not to mention the emotional and economic toll carrying even a modest amount of debt can have.

Here are seven ways debt can affect your financial well-being.

1. Interest Eats Up Your Budget

Debt offers a temporary increase in your purchasing power. You can afford to buy what you want now, paying it off over time from future earnings. It’s important to understand, however, that the downside of this approach is that your future earnings are now going to be spread much thinner.

If you are carrying an average balance of $5,000 on your credit card at a 21% interest rate, this ‘revolving debt’ is costing you more than $50 a month in interest charges. Over a year, that adds up to more than $600 in money spent on interest, rather than necessities or extras.

The danger this presents is a cycle of credit creep. As your credit card debt increases, your interest costs and minimum payment requirements rise. If your income isn’t increasing, interest begins to consume a larger and larger percentage of your take-home pay every month, making you even more dependent on credit to get by.

The solution is to reverse direction. Pay off all debt, no matter what kind, as fast as possible. If you are carrying credit card debt, take a cold hard look at your budget and find ways to increase your debt payments to reduce your balances sooner.

2. Amortization Is Not Always Your Friend

When you have to borrow money, look for the cheapest long-term option available. This means looking at the total cost of the loan, not just the monthly payment.

Let’s consider an example. You need a new car and your bank agrees to loan you $20,000 over three years at 3.25% interest. That equates to a monthly payment of $583.83. Unfortunately that payment doesn’t fit into your budget. Your car dealer offers a monthly payment of just $308.37 a month. Is it a better deal?

The truth is to lower your payment your car dealer extended the term to six years and they raised the interest rate. The second option will cost you $2,203 in interest ($308.37 x 72 months less the purchase price of $20,000) and at the end your car is six years older. The bank loan would have only cost $1,018 in interest with your car full paid off in just three years.

Generally speaking, you are better off in the long run by pushing for the shortest amortization period you can when you take out a loan. The faster you pay off any credit, the less you pay in interest. If you need to lower your monthly payments, lower the amount of money you are borrowing.

Want to use amortization in your favour? Pay more often. If you can arrange a weekly rather than a monthly payment, then you benefit from the fact that your principle payments are being reduced faster. Make extra payments whenever possible.

3. Debt Is a Deterrent to Saving

Easy access to relatively cheap credit provides little incentive to save for a rainy day. In both an American and a Canadian survey in 2012, respondents were asked if they could come up with $2,000 in 30 days for an emergency. In both studies, 1 in 4 said no. What was even more concerning is that 92% said they would rely on some form of borrowing to deal with a short term crisis.

The fact that the results of both studies were so similar shows how reliant on credit we have become.

Debt prohibits your tendency to set money aside. Whether this is because your debt repayments are taking up too large a portion of your income, or because you don’t think savings are important right now, doesn’t really matter. The end result is the same. Little savings and lots of debt.

A good long-term financial plan provides for both the repayment of debt and the build-up of savings. Begin by preparing a budget that improves your cash flow. Put the largest portion of those savings toward debt repayment, but set aside a small amount each month into a separate account as an emergency fund.

Having savings to rely on while in debt helps keep you motivated. Let’s say you’re paying off $1,000 each month against your $20,000 credit card debt with a goal to be out of debt in two years. There is nothing more disheartening than finding out you have to divert this month’s debt repayment because you need to pay the plumber or your car mechanic for an unplanned repair.

Here’s the other reason you shouldn’t ignore savings while in debt. Depending on how much debt you have, you may have less than stellar credit. A poor credit score increases the cost of any new credit you do obtain. Purchase a car and your interest rate will be higher. However, if you have enough saved to make a larger down payment, you’re a lower risk to your lender, and it’s more likely that you’ll be able to obtain a more attractive interest rate.

4. Debt Limits Freedom of Choice

One of the biggest emotional costs of carrying debt is that you no longer have the finances to do what you want. If you are carrying a lot of debt, you can’t afford to take a vacation, you avoid going out, you feel pinched.

Even good debt limits your freedom of choice. Carrying a large mortgage on a home limits your mobility. Many saw this play out during the financial crisis. Relocating for a new job means selling your house where you live today. Even with the slow recovery we are now experiencing, the sales process can take longer than you expect, and force you to accept a price that may, or may not, repay your mortgage and provide you with enough of a down payment on a new home.

If a significant portion of your monthly income is tied up in debt payments, what happens when something goes wrong? Your debt load might be manageable today, but what happens when you, or someone in your family loses their job, becomes ill, or passes away?

This lack of freedom can lead to more bad financial decisions. When credit card repayments are already taking up 20% to 25% of your income and you need a new car, what do you focus on? That dreaded monthly payment again. That means you look for any option that will permit you to keep up with a new car loan or lease payment. You may be forced to deal with a lender who offers low credit score loans. The downside is higher interest costs, and potentially higher fees as well.

5. Debt Delays Retirement

One of the fastest growing risk groups in terms of bankruptcy are pre-retirement debtors. These are individuals aged 50-59 who suddenly find their retirement plans set aside as they continue to struggle to make huge monthly debt payments.

Despite a higher than average income, there are more demands today on the average 55 year old. Sandwiched between children in college, adult children forced to return home, and aging parents, they find their income stretched further than they ever anticipated.

While every person’s retirement needs will differ, few will be able to live comfortably without any supporting savings. If you believe you are going to need to supplement your income during retirement by at least $10,000 a year, you will need to be able to set money aside regularly.

If you are in your 20s, that means saving $130 to 140 a month every year until retirement. Carrying $5,000 in credit card debt at a 21% interest rate eats up $88 a month.

If you wait until your 30s to start saving for retirement, your retirement savings have to increase to $200 to $225 a month. If you are carrying just $12,000 in credit card debt you are effectively paying your potential retirement fund in credit card interest.

If you are carrying debt into your 40s and 50s, you’re likely facing a retirement hurdle you can’t surmount.

The sad truth is, most never plan for this to be the outcome. What happens is they wake up at 55 and ‘suddenly’ find themselves buried in debt.

6. Debt Has An Unexpected Life Cycle

Regardless of age, one of the largest inherent costs of carrying debt, any debt, is the added risk factor when things go wrong. This is what, for more than a million people a year in the United States and over 100,000 a year in Canada, leads to bankruptcy.

Our firm’s research shows that it is the unexpected life event that often triggers the need to file bankruptcy. Most expect to pay off their debt. Often they are surprised to find out they cannot.

The top causes of bankruptcy, beyond financial mismanagement, are unplanned life events.

Even with Medicare, illness and injury is one of the most often sited causes of bankruptcy. It’s not just the obvious costs of medical bills either. When you are sick or injured, you can’t work. Without a stable income you can’t pay your bills.

At first you turn to credit cards just to make ends meet, fully expecting to be able to pay these debts off once you do return to work. But what happens when you don’t return to work or return to a limited income and continued medical costs?

Income reduction is also something never planned or thought out. And this doesn’t have to be an event as severe as a permanent job loss. Your work hours may be reduced, or a spouse may take time off to have children. If you are carrying debt, and have no emergency fund, you are unlikely to be able to keep up.

Default adds penalties and fees, increasing your debt costs. If you’re not able to return to work at a similar income level, you may find yourself unable to stop creditors from pursuing you legally without filing bankruptcy.

Unfortunately, using credit as a temporary stop-gap often becomes a permanent problem. Just $200 a month charged to a credit card for groceries, gas, bill payments, or whatever else you need while your income is reduced, balloons to a balance of more than $2,200 in just 12 months. You would have to pay $110 a month to pay this off within 2 years. And that’s assuming you didn’t have credit card debt to begin with.

7. Debt and Divorce

Carrying too much debt adds to the strain in a marriage. While not all families with debt will end up divorced, and while all divorces are not caused by money problems, there is definitely a correlation between debt and divorce.

More than one-quarter of all bankruptcies we see are for individuals who are divorced or separated at the time they filed bankruptcy. And almost 1 in 5 cites a marital breakdown as the primary cause of their bankruptcy. It’s easy to see why. Debts you could barely afford in a two-income household become unmanageable when you separate.

While debt doesn’t necessarily equal divorce, it certainly adds to the risk and adds to the complications of settling up in a divorce or separation. Joint debts, loans owed by both spouses, need careful legal planning in a divorce. Examples would include a mortgage or bank loan where both spouses signed for the loan. Even joint credit cards can lead to one spouse becoming liable when they did not expect to.

In the case of joint debts, both spouses will remain liable unless the original lender agrees, in writing, to remove one party. A divorce or separation agreement by itself cannot absolve one spouse of their legal obligation under a loan agreement.

Debt Complicates Things

Simply put, debt is complicated. Yes, you will pay interest — but you will pay much more.

  • Debt grows faster than you expect.
  • Debt takes longer to pay off than you expect.
  • Debt adds risk when life throws an unexpected curveball.

All of this puts your future at risk. If you are going to take on any debt, look beyond the monthly payment to your future. Make sure you don’t pay for your debt for the rest of your life.

Doug Hoyes has extensive experience resolving financial issues for Canadian citizens. A Licensed Bankruptcy Trustee and co-founder of Hoyes, Michalos & Associates, he is also a Chartered Professional Accountant (CPA), Chartered Insolvency and Restructuring Professional and Business Valuator. He regularly comments on a variety of TV, radio and other media outlets on topics surrounding bankruptcy and writes a column for the Huffington Post. Hoyes has been a Licensed Trustee since 1995 and testified before the Canadian Senate’s Banking, Trade and Commerce Committee in 2008.