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Financial Literacy Month: Paying down debt

Canadians are no stranger to debt, with households carrying approximately $2.5 trillion in outstanding debt, one year into the pandemic. It’s a widespread problem that puts a lot of strain on individuals and families. According to the 2021 BDO Affordability Index, 43 percent of Canadians added to their existing debt during COVID-19 lockdowns. “Debt stresses a lot of people out,” says Jackie Porter, a Certified Financial Planner. “As a financial planner, it’s important to look at helping the client sleep at night and giving them a sense that they are making a dent on the overall debt that is being tackled.”

If you’re in debt, the first step to financial freedom is getting back in the black. This article answers eight common questions to do with debt repayment and offers savvy strategies for getting your balance to zero.

1. What is debt and where does it come from?

Debt is any money that one person owes to another person or entity (like a bank or credit card issuer). Common vehicles for tapping into credit can include using a credit card, charging a purchase to a line of credit, taking out a personal loan, borrowing to pay for education, or choosing a “buy now, pay later” plan.

2. How does debt work?

Generally, debt works like this: You need access to cash that you don’t have sitting in the bank. Or in some cases, maybe you have the funds but don’t want to dip into your savings. Instead, you borrow money from a creditor, who typically charges an interest rate—an amount tacked on top of the “principal” (the amount you borrowed)—to compensate for the temporary loss of the funds.

The interest rate is usually expressed as a percentage, such as 1.50 percent or 4.99 percent. This means that you’ll be paying back more than what you originally borrowed from the lender. Also, make sure to consider the annual percentage rate (APR), which is the yearly interest rate. While APR is based on the interest rate, it also takes into account any extra lender’s fees and other costs to obtain the loan.

3. What does it mean to “pay down debt?”

Paying down debt is the process of paying off your loans. “It means paying down or paying off an amount of money you owe the creditor,” says Porter. With every payment, you’re actively reducing the amount that you owe to a lender. Often this requires taking stock of the situation by figuring out the total of what you owe, then coming up with a plan to pay it off (see #6).

4. How much interest will I pay?

The interest you will ultimately pay depends on many different factors: the interest rate (variable vs. fixed), the term (the time set out to repay the amount borrowed), the payment frequency (weekly, biweekly, monthly, etc.), whether the loan is open vs. closed, and other factors. These are all negotiated with the lender at the time of borrowing the money. It also depends on how long it takes you to repay the loan (e.g., if you’re making minimum payments or extra lump-sum payments). Getting a handle on the full impacts of an interest rate can be important to your bottom line.

5. What are the benefits of paying off debt faster?

Depending on your loan agreement, you may be allowed to pay off your debt faster, sometimes without penalty. It may sound ambitious to be the early bird on debt repayment, but aggressively paying off debt has its advantages.

“The biggest benefit is fewer monthly obligations and more cash flow for yourself,” says Porter. “Nothing feels better than receiving your paycheque and having less money going out to debt repayment.” Bottom line: the less money you owe, the more money you can redirect toward your financial goals.

There’s also the benefit of less stress in your life. Many Canadians report that money worries are their greatest source of stress—even more so than work, personal health, and relationship stress. Research shows that 48 percent of Canadians say they’ve lost sleep because of financial worries. And for those in debt, 40 percent say that it’s negatively impacted their mental health.

Another key benefit: Attacking debt generally means paying less interest overall, which has the most impact on your wallet. Let’s say you take out a $25,000 car loan with 4 percent interest and a biweekly payment. Using the Coast Capital’s loan calculator, here’s how much interest you’d pay over one, three, and five years:

Here’s a quick snapshot of the difference between the two savings product:

Interest rate Term Repayment frequency Loan payment Interest paid over term Total payment amount
4.00% 5 years Biweekly $212.33 $2,602.36 $27,602.36
4.00% 3 years Biweekly $340.37 $1,549.24 $26,549.24
4.00% 1 year Biweekly $981.64 $522.55 $25,522.55

As the chart shows, the faster the debt is repaid, the less interest you owe. That’s cash you could stash in a high-interest savings account or invest in a RRSP or TFSA instead.

6. How can I pay down debt fast?

There are two popular approaches. There’s the “debt avalanche method,” which involves paying the debt with the highest interest rate first while making minimum payments on your other debts. “When you focus on paying off the highest interest rate debt, you can shave years of the interest you would have otherwise paid,” says Porter.

On the flip side, there’s the “debt snowball method”—aggressively paying off the smallest amount of money owed first and making minimum payments on the rest. Some find this method more motivating to wipe out debt. “Some clients feel good when they make minimum payments on all of their debt and focus on paying off their smaller debts first,” says Porter. “But keep in mind that although this may be more motivating for some, they are still paying more interest in the long run.”

7. Is it better to pay down debt or save?

This question often depends on how much debt you owe, how much interest you are paying on your debt, and your credit rating. “If you have low savings, high-interest debt, and poor credit, chances are you would be better off paying your debts and saving yourself the interest the creditor is charging as it can quickly become a vicious cycle,” says Porter. “Once you get rid of this debt, funds that were going to interest could easily be redirected to savings. Also, you are often rebuilding your credit when you are paying down debt, which will reduce the interest costs you will pay in the future when you may want to borrow again.”

If you’ve got a credit card balance at 19 percent interest or a loan at 29 percent interest, that can be considered “bad debt.” With debt at those high rates, it almost always makes sense to use spare cash to pay off the balance in full every month (or pay as much as you can beyond the minimum) and saving on interest charges.

However, aggressively paying down debt may not be the best option for those with an emergency fund, a good credit score, and low-interest debt. After all, why make extra payments on a $10,000 car loan at 2 percent interest when you could snag a 7 percent annual return by investing the money instead?

“We are in a low-interest-rate environment,” says Porter. “Directing savings toward paying off a low-interest mortgage, for example, may not be the best use of your cash when investing in the markets [currently at historic highs] could reap larger returns and growth for retirement.”

8. Need to kickstart a plan?

Tackling your debt may seem overwhelming, but it can be doable. Half the battle to becoming debt-free is knowing what you owe; the other half is committing to a way to pay it off. Porter says, “Write down all your debts, listing the interest rates and minimum payments, and then stick to a plan to get it paid.”

Coast Capital’s Money Manager can help you get on track with tutorials and instruction. It’s a free tool you can access through Coast Online Banking or the Coast Mobile banking app that explores different strategies to pay off your debt and creates a suggested payment plan, helping to get your balance down to zero.

“Nothing gets better until you face a situation head-on,” says Porter. “And, if you need the help and support of a professional, seek out the services of someone you trust.”

Speak to an advisor on the Coast Capital team to help you find the right budgeting solutions for reaching your debt goals.

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This article is provided for general information purposes only. It is not to be relied upon as financial, tax, or investment advice or guarantees about the future, nor should it be considered a recommendation to buy or sell. Information contained in this article, including information relating to interest rates, market conditions, tax rules, fees, and other investment factors are subject to change without notice, and Coast Capital Savings Federal Credit Union is not responsible for updating this information. All third-party sources are believed to be accurate and reliable as of the date of publication and Coast Capital Savings Federal Credit Union does not guarantee the accuracy or reliability of such sources. Readers should consult their own professional advisor for specific financial, investment, and/or tax advice tailored to their needs to ensure that individual circumstances are considered properly and action is taken based on the latest available information.

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