Debt may seem overwhelming but it can be nibbled down to nothing sooner than you think if you have a plan that keeps you feeling encouraged.
By James Daw, Toronto Star
Jessica and Michael poured their hearts and registered retirement savings plans into a rural home large enough to raise a family.
Three years later they have about $47,000 in home equity, two secure jobs just a half-hour drive away, both their first child and a grandmother willing to babysit, and a pension plan for Jessica. They have a bright future.
They would be more secure, however, if they could clear away the $64,000 in debt they have on top of their $193,000 mortgage and if they could increase their $117,000 in annual income.
“There is no extra money at the end of the month,” says Betsy Prospero, a certified financial planner with a knack for inspiring young couples.
Prospero, an associate at Fiscal Wellness in Stratford, Ont., has proposed a 46-month workout plan for Jessica, 29, and Michael, 31.
Most of their debts are a hangover from Jessica’s time at university to qualify for her current research job and Michael’s purchase of a pickup truck for his construction job. So these expenses were arguably investments in their future.
Even so, Prospero suggests taking a part-time job if necessary. Regardless, she suggests they take the $200-$250 a month they put into retirement savings and redirect it to debt repayment.
Under the Federal Home Buyer’s Plan, they can either return the $9,000 they withdrew from their RRSPs to buy their home at a rate of 1/15 per year or pay income tax on that $600 each year.
Prospero feels repaying credit card and other high-interest debt is simply more pressing than saving for retirement at their age. This will beat any returns they can earn inside their RRSPs.
To free up additional cash, she suggests they ask their insurance agent to find suitable coverage costing at least $1,200 less per year than the $3,360 he persuaded them to pay.
“Spending on life insurance is very high (for your income),” Prospero said. “You need to lower expenses for approximately five years. See what solutions (the agent) can come up with.”
She also urges them to reconsider their child’s $25,000 life insurance policy, which costs $600 a year. They were told the cash value could be used to help pay for post-secondary education. But a better strategy would be to add a rider to their own life insurance for the child.
This would likely save $40 per month, which they could direct to their debt repayment. When their debt is under control, they could apply this to their child’s Registered Education Savings Plan, which qualifies for government grants.
“To start tackling the debt, first pay Jessica’s (smallest) credit card debt,” Prospero urges. “This will be gone by month two. Then $300 a month, plus $50, will go toward Jessica’s second credit card debt. After month eight, this will be paid off. Then $350, plus $50, will go to pay Michael’s credit card debt, and so on until Jessica’s smallest student loan and Michael’s credit union loan are repaid by month 15.”
It is standard advice to apply extra cash to paying credit card debt before other loans. But Prospero prefers to erase the smallest debts first. This creates an encouraging sense of momentum. Then she uses a combination of debt payments and saving for a rainy day or for fun.
Prospero is not a fan of debt consolidation. “It’s psychological. When you systematically pay each debt off in the above manner, you get a sense of accomplishment. If you consolidate debt, in six months to one year, people usually sign up for a new credit card or line of credit and are right back in the same position – actually worse off because you now have additional debt.”
She foresees Jessica and Michael repaying his line of credit six months before repaying the loan secured by his truck. Once out of debt in 46 months (apart from their mortgage), she forecasts they will have $1,340 a month to save.
A reserve equal to six months to a year of income is next on the list. It is important to have a large emergency fund in case Michael is hurt or disabled. He has no insurance for long-term disability, which is a greater risk than death at his age.
First published in the Toronto Star on Nov. 5, 2012.
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