When it comes to debt, all your eggs do belong in one basket

Do you have debt? A mortgage? A car loan? Credit card balances? A line of credit? You're not alone. A recent survey conducted by Maritz Research1 found that 55 per cent of Canadian homeowners surveyed currently have some sort of household debt.

But a more important question than if you have debt is what are the interest rates you're being charged on each of your debts? This is key – you may be paying a lot more than necessary each year to service your debt through interest. And you could save some of that money easily by simply moving all your debts into one place at one low interest rate, according to a study2 done recently by Professor Moshe Milevsky, Associate Professor of Finance at the Schulich School of Business, York University, and Executive Director of the Individual Finance and Insurance Decisions Centre (IFID) in Toronto.

"We were actually quite amazed at how much Canadians lose by diversifying their debts," said Milevsky.

According to the study, Canadians have their debts (including mortgages, car loans, credit cards, lines of credit, etc.) spread out (or diversified) across a number of different creditors, all at different interest rates. The study refers to this situation as "space diversification." Although consolidating all your debts with one creditor at one low interest rate can immediately save you money in interest charges, the Maritz Research survey found that only 33 per cent of Canadian homeowners with debt surveyed have ever tried this approach. And nearly 40 per cent of these survey respondents said they had not consolidated their debt because they believed there is no advantage to debt consolidation. But Milevsky's study clearly indicates there is an advantage to consolidating your debts – one that can add up to annual savings for the average Canadian.

The study uncovered something even more interesting. Milevsky found that the key for Canadians to realize the most savings is not only to consolidate their debts, but to consolidate their debts with their short-term savings into one line of credit – so they can get their money back out again whenever they need it. What Milevsky discovered is that Canadians are not only practicing space diversification but they are also practicing what he coined "time diversification." This is where debts aren't paid off as soon as the funds are available. Discretionary income and savings are not used immediately to pay down debt but, instead, wait in low-interest accounts while interest owed on other debt accumulates at higher rates. For example, a person's pay cheque is being deposited at the beginning or end of the month but their debt and interest are not being paid until the middle of the month. That lag in time is harmful, Milevsky states.

To diversify or not to diversify - a tale of two families
To illustrate the advantages of consolidating debts and using short-term savings to reduce debt, Milevsky draws a comparison between two fictitious families: the Diveronicas and the Consuelos. Using real data based on the habits of Canadians, Milevsky shows how an average family can save money simply by consolidating their debts and their savings into a flexible line of credit.

The first family is the Diveronica family – with debts and liabilities spread over a number of various creditors. In total, the Diveronicas owe a total of $94,709. The family contributes $1,000 toward the repayment of their debts each month and allocates it in the following way:

•  For their outstanding mortgage, the family makes a monthly payment of $516. This is based on a 20-year amortization period and an assumed fixed three-year term interest rate equal to 5.35 per cent.
      
• Their auto loan charges interest of 7.93 per cent and they make a monthly payment of $320.90.
      
• They make the minimum monthly payment due on their credit card each month (assumed to be the maximum of $40 and two per cent of the outstanding balance).
     
• The remainder of the budgeted $1,000 is used to pay down the line of credit.

Next, Milevsky introduces the Consuelo family. They live next to the Diveronica family and, as fate would have it, owe the exact same amount to the exact same creditors. However, in contrast to the Diveronicas, the Consuelos have decided to consolidate all of their debts – totalling the same $94,709 – under one line of credit or liability account. The Consuelos make the same monthly payment of $1,000 as the Diveronicas, but it is entirely allocated towards the line of credit, which currently charges an interest rate of 4.5 per cent.

In the process of completing the study, numerous scenarios were created using Milevsky's financial simulation and the average result was that the Consuelo family will owe $929 less than the Diveronicas in the first year and $970 less than the Diveronicas in the second year.

The Consuelo family is acutely aware of the fact that prime interest rates are likely to increase over the next year or two, but they are reasonably comfortable knowing that the benefits of debt consolidation outweigh the risks of higher interest rates (Milevsky's analysis indeed confirms this intuition). In fact, the study found that even if the prime rate increases steadily over the course of three years, there are still significant benefits of consolidation for the first two years, but this ends in the third year. As one would expect, if short-term interest rates move well above the fixed rates that are being paid on mortgage debt, the consolidation strategy will no longer add value.

All the eggs in one basket
Now, what would be the financial impact of embracing both consolidation strategies simultaneously, eliminating not only space diversification (by putting all debt "eggs" in one "basket"), but also eliminating time diversification (by putting short-term savings and income against debt)?

Milevsky proposed that our two families have the same debts as mentioned above. That is, the Diveronicas owe $94,709, spread across a mortgage, car loan, line of credit and credit card, while the Consuelos have consolidated all four debt balances under a single line of credit. Both families also continue to make fixed monthly payments of $1,000 towards their debts. However, now, the Diveronicas also maintain a savings account (or "emergency fund") with a $2,700 balance.

Conversely, the Consuelos, who previously consolidated their debts into a line of credit, used their $2,700 to pay down their debts, reducing the total debt of $94,709 to $92,009.

At the end of the first year, the outstanding liabilities of the Consuelo family will be $3,763 less, on average, compared to the Diveronica family. Then, taking into account the $2,700 cash fund the Diveronicas will have at the end of the year (earning negligible interest), the Consuelos will be $1,063 better off. At the end of the second year, the Consuelos will be an additional $1,289 better off than the Diveronicas, on average.

In conclusion, the Milevsky study on Canadians' debt habits shows that a typical Canadian family holding a diversified portfolio of liabilities of $95,000, including a residential mortgage and maintaining an idle emergency cash fund of $2,700, loses more than $1,000 dollars per year on average from not managing its debts in an optimal manner. The study arrived at this number by assuming that the family consolidated all of its debts and the cash account under a (floating) personal line of credit linked to the prime rate – while making the exact same monthly payments as they would have otherwise, instead of making smaller separate payments to each creditor individually.

"Canadians can do three things to apply the results of a study like this," says Milevsky. "They can:

•     Consolidate all their debts at as low a rate as possible
     
•     Make sure they don't have excess cash sitting around, perhaps in an emergency fund or in a savings account or in a chequing account for that ‘rainy day.' Make sure it's being used to pay down debts as soon as possible because, after all, they can borrow money when they need it from that same line of credit.
    
•    Notice that the interest earned on their savings is going to be taxable where the interest on their debt is not going to be tax-deductible. It's inefficient to manage your debts this way. Make sure to pay down your debts and, in a sense, earn a much better aftertax rate of return by paying down your debts."

Of the two-thirds of Canadian homeowners surveyed who have never consolidated, surprisingly 45 per cent prefer to keep their borrowings separate and 39 per cent of them haven't done it because they believe there's no advantage to consolidating. In his study, Professor Milevsky proves otherwise.

Discover the advantages of consolidating that other Canadians have already discovered. Talk to your financial advisor today about consolidating your debt with your savings in a personal line of credit and enjoy the savings of having all your eggs in one basket.

1. The survey by Maritz Research conducted between September 15 – 21, 2005 of Canadian homeowners has a margin of error of +/-2.73 per cent, 19 times out of 20. The number of Canadian homeowners surveyed was 1,261.
2.  For a full report of the study, visit www.ifid.ca/research.htm. Thanks to the IFID Centre for all references made to the study findings.