The True Cost of Debt

       Canadians love debt. According to Statistics Canada, household debt is currently around 177.5 per cent of disposable income. This means that the average Canadian owes about $1.78 for every $1 earned in income.

        With interest rates still near historical lows, many people wonder how harmful debt really is. The answer lies in a simple debt analysis, which will be described in this article.

Good and bad debt

        It’s widely reported that about 70 per cent of Canadians carry some form of debt; however, not all debt is created equal. Mortgages, business loans and investment loans are often referred to as good debt, because of their potential to earn income and/or capital gains.  

        Consumer debt is less productive, and therefore, generally considered to be “bad” debt. This would be defined as consumables and many heavily depreciable assets that don’t earn income, or help a person earn income, such as clothing, restaurants, hot tubs and vehicles. Currently, the average Canadian owes about $23,271 in consumer debt.

The true cost

        The cost of debt can be thought of as two components. The first and most obvious are interest and other costs associated with carrying debt. With interest rates as high as 30 per cent for some retail credit cards, it doesn’t take long for the numbers to add up.

        The second component is likely even more significant: the opportunity cost. Simply put, the money used to pay off debt could have been invested instead.

        For example, consider a 30-year-old with credit card debt. He decides to pay it off in one year, which would cost him $500 per month, including interest. When his credit card is paid off, he decides to contribute the $500 per month into a Registered Retirement Savings Plan (RRSP). The RRSP grows at a rate of 6 per cent annually until he is 60 and decides to retire. His RRSP is worth $456,071.

        Now consider this 30-year-old didn’t have any credit card debt and therefore, started investing one year earlier. If he had, his RRSP would be worth $489,628. In other words, the cost of his debt was only $6,000 but the opportunity cost was $33,557.

How to reduce debt

       There are a few ways to reduce debt. The first and most obvious is to pay it down as fast as possible. This is a good option for smaller amounts, or people with high cash flow. The second is to consolidate higher-cost debts at a lower rate, either with a personal loan or line of credit. It may even be possible to consolidate personal debts with one’s mortgage, but this should not be done habitually.

        The third point is pre-emptive: reduce spending or work more to ensure there is enough money to avoid consumer debt and save for the future. This may be easier said than done, and every situation is different, but may be necessary to keep debt from escalating.

Final thoughts

        Generally, a household’s income is enough to provide for the basic necessities of life, plus some for saving and discretionary spending. It’s not magic; the developed world is set up this way. The balance lies in figuring out what is reasonable and what is excessive.

        Investment opportunity costs may be pricey, but the alternative is worse. With a few exceptions, debt generally costs more than guaranteed investments like GICs will return, so always pay off high-interest debt first.

        To learn more about debt consolidation options available to you, visit your local bank or credit union and speak to a loans officer. To learn more about budgeting, speak to a financial advisor or find a template online. There are a lot of resources available to help you get started.