Helping clients tackle rising debt

(July 28, 2003) Canadians may be in for a shock if interest rates were to rise suddenly, according to Myron Knodel, manager of tax and estate planning at Investors Group.

“We have a lot of baby-boomers who are nearing retirement age and you’d think that we’d be getting to a point where a lot of mortgages are getting paid off, the debt is getting paid off as well and we’re in an accumulation phase,” says Knodel. “But it appears that we’re going the opposite direction, with our debts going up. I think there is a lot of impulse consumer spending that is contributing to that.”

Knodel says consumer debt levels have risen 9% over the past year, while savings have dropped 3%. It is the flip side of the “paradox of thrift:” while building savings is good for the individual, it creates a drag on economic performance.

“This is good for the economist. It helps the economy as a whole, at least in the short term,” says Knodel. “But as far as an individual’s balance sheet is concerned, over time it could be a problem.”

Besides the burden of making monthly-debt servicing payments, the debt-laden consumer may face a postponement of retirement as their savings are drained by interest payments. While the rates may be low right now, any sudden movement upward could spell serious trouble for those carrying debt.

“If we were to experience some increase in levels of unemployment or slowing of the economy in general, that always puts pressure on household debt and repayment,” warns Knodel.

“If you have a client that has a problem with spending in general and needs some element of control in their life to make sure they don’t spend too much, I think a strict budget is a way to start.”

No one likes to be told how to spend their money, so discussing a client’s indebtedness can be a delicate topic. Knodel says that a good approach is to develop a personal financial plan. This plan needs to take into account the client’s existing resources, their income sources, current debt levels and their objectives.

How soon do they plan to retire? How much will they need to retire at that age? How much do they have saved? Once these questions are answered, Knodel says a client may be shocked to learn just what effect their debt is having on their retirement plans.

“Sometimes when people see this, their future goals are somewhat diminished. They say ‘we’re just not going to make it.'”

A properly devised financial plan will determine what the client can afford to spend today without compromising their goals for the future.

“When you have this whole picture in perspective, it can give you more confidence in your spending and in your buying habits.”

Knodel says many consumers consider credit to be the only way to make a major purchase. But he suggests that if the item is not needed immediately, the consumer may be better off saving for it. It sounds like a simple, old-fashioned notion, but it forces the consumer to realize how long it takes to make a purchase.

A purchaser might not take into account the numerous fixed costs they face in a month, before arriving at their discretionary income.

“I work, I have to pay my taxes, then I have my necessities of life: I need a roof over my head [and] I need food and clothes. So that takes another portion of my income. What portion of my life do I need to devote to that [purchase]? It gives it a whole different perspective.”

“You can develop a savings strategy over a period of time, then have the money and then make the purchase.” When people see what it takes to save up that much money they sometimes come to the conclusion that it’s not worth the time it will take to make the purchase.

A 42-inch plasma television might seem like a steal at $7200, but if your discretionary income is only a couple hundred dollars a month, it won’t take long for the credit card interest to inflate the true price of at dream TV into a nightmare. At $260 per month, it will take three years and $2170 in interest.

Part of the increase in debt levels Knodel credits to the housing boom, as more and more Canadians takes advantage of low mortgage rates and purchase homes. But more dangerous is the accumulation of retail debt. Consumers are inundated with ads offering “zero down and no payments for 12 months.”

Far too often, Knodel says, consumers take on these debts without calculating the end costs into their budget. When these debts come due, the consumer may not be in any better position to make the purchase than when they entered the agreement.

Knodel’s advice for debt reduction is to follow a well-known path. If your client cannot manage to get their loan principal paid off, the best route will likely be to for them to consolidate high-interest credit card debt into one, lower-interest bank loan. Assuming they have learned from the budgeting exercise and don’t start running their cards back up, the monthly payments should be much lower. As the principal starts coming down, they can start getting back on track investing for their future, rather than spending for the present.

Filed by Steven Lamb, Advisor.ca slamb@rmpublishing.com

07/28/03

Steven Lamb