Avoiding The Debt Trap

debt-trap

I really did mean debt trap, not death trap, but it might as well be the same. The recent spate of interest rates cuts around the world by central bankers have led to some of the lowest borrowing rates ever. Heck, in some parts of Europe we actually have negative interest rates! Who would have thought that it would actually be possible to get paid to own a mortgage.

With money so cheap, it’s no wonder that families and individuals are running to their banks to get loans. This has led to a mountain of consumer debt that has grown over the years since the 2008 stock market crash. The average Canadian has now accumulated enough debt to push the income to debt ratio over 162%. This means it would take more than a year and a half of a person’s income to repay their debts. No doubt many of those debts are due to large mortgages, but despite the many warnings by our federal Finance Minister and the Bank of Canada not to take on more debt, we pile on more and more. It’s so easy to pig out on free money isn’t it?

Debt Is Not An Asset

A troubling theme among many individuals is that they view debt as being an asset. Money buys things. If borrowed money can be spent to buy goods and services that we want then we think of it assume it’s an asset. We have even tried to convince ourselves that there is such a thing called “good” debt. Student debt, and mortgages are all good debt because they are going towards things that are perceived to be an investment. What many people neglect is that we still need to pay off our debts. We can’t just keep accumulating more without worrying about the consequences down the road.

Cash Flow

Having too much debt has a negative effect on a person’s cash flow. In general, interest payments on debt are due on a monthly basis. Excess debt creates undue stress on a person’s monthly finances because rather than consuming the money on everyday needs, that person is inundated with interest payments. Even individuals that make an above average salary can feel “poor” because they’ve borrowed so much that their monthly financial obligations far exceeds what they earn.

While interest rates are low it makes it very easy to pay off the interest, but what happens when interest rates are no longer low? This was one of the hardest lessons learned by American’s in 2008 when interest rates for mortgages were raised in subprime loans. This caught many people off guard and then they realized that they couldn’t make the payments on their homes. The current generation of individuals subscribe to living in the moment, yet sometimes for financial purposes that isn’t the most prudent decision.

Don’t Listen To Your Banker

Nm_scotiabank_queen_mccaulThe local bank manager and financial planner are some of the nicest people that one will ever meet. The unfortunate news is that when it comes to the financial well-being of their clients, they don’t always have their customer’s best interest in mind. A bank is focused on providing the best return for its shareholders. They are not there to help promote prudent financial planning. A bank is more than willing to provide bigger and longer term loans so long as the individual is able to pay the interest.

This is where the trap lies for many individuals when it comes to acquiring debt. It is so easy to be manipulated into buying a house, or financing a car when in fact the individual does not have the means to pay down the principal on the debt. The best debt to a bank is one that is never repaid. This may sound counter intuitive, but if the individual never repays the principal, then the bank will continue to reap the benefits of interest payments forever.

Getting Caught With Your Pants Down

One of the riskiest propositions with debt is using it for investment purposes. Since interest rates are so low, it might be a compelling reason to borrow at these low rates to invest in additional properties or the stock market. Despite our past mistakes, humans are driven by greed and will continue to commit the same mistakes as our predecessors.

One of the most popular forms of loans that individuals in Canada are tapping into is their home equity. Since home prices have gone up substantially over the last 5 years, Canadians are taking out loans through home equity lines of credit or backing personal loans against the value of the property.

Things can get extremely difficult if home values start to decline or if individuals are unable to pay their loans back. It’s quite possible that lenders can call back on their loans if home prices fall or if individuals fall back on their payments. This is almost akin to buying stocks on margin only using homes as collateral and we all know how bad that went down during the Great Depression.

Too Much Is Enough

MalnurishedManHungryForCarrotSometimes as individuals we just have to learn to say no. In some circumstances during life, it is bad to have too much of a good thing. Even if it means taking free money we need to learn to say no. We have to realize that all of these loans have strings attached to them that make it harder for us to accomplish our financial goals. That is to become financially independent.
If we ever want to feel like our financial lives are not being run by the government or the bank or some other external force that is out there to get you, then it’s better to leave the carrot that’s extended out in front of us.

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