Cornerstone of a solid financial plan - Wise debt management

Two years ago, David moved to a new city and put quite a few purchases on his credit card as he furnished a new home. Then, unexpectedly, his car needed expensive repairs and David was forced to put those on his credit card also. Now, the cost of living in the city and his high credit card bill has David feeling like he's being controlled by debt and wonders how he'll ever get ahead financially.

Terri and Sam are looking to buy their first house. They've been saving for their down payment for three years and are now ready to speak with a mortgage specialist. A friend of theirs tells them that they should go with a floating interest rate to save money but they like the idea of locking-in to a five-year rate so they will know exactly what their mortgage payments will be for the next five years. And they're thinking too that this may be the best time to lock-in because interest rates are still low.

Sarah knows it's important to have some money tucked aside for emergencies – a "rainy day" account, her mother used to call it. And, over the past couple of years, she's managed to save $10,000 in her savings account. Lately, she's been wondering if she should do something more with that money but wants to make sure she doesn't lock it in so she can get at it if the need arises.

THEY ARE CONNECTED
Do any of these scenarios sound familiar? In a national survey done recently for Manulife Bank of Canada, Maritz Research found that almost seven in 10 Canadians are concerned with how they'll handle their mortgages, credit card and other debts if interest rates keep rising. And nearly three-quarters of those surveyed said they gained little or no ground in reducing their debts or increasing their savings in the past year. Key concerns for most Canadians are how to manage their debt and how to get the most out of their savings.

In fact, solutions to these two issues – reducing your debt and increasing your savings – could actually be more closely tied than many people may think. But first, let's take a closer look at debt.

GOOD DEBT AND BAD DEBT
Many people have been brought up to think that all debt is bad. But this is a myth. Debt should actually be divided into three categories: expensive debt (nontax-deductible) like what is often accumulated through high-interest rate credit cards; regular debt such as mortgages, lines of credit and car loans; and taxdeductible debt that people incur for the purpose of making money, such as investment loans. This last type of debt should be classified differently than the others because it is a tool used for building wealth (good debt). What you may not know is that there are ways to convert your expensive debt into regular debt and your regular debt into tax-deductible debt.

Take David's situation, for example. His living expenses and credit card debt are so high that he's having trouble paying the interest on his debt, let alone reducing the principal. David is caught in a circle of debt right now but he has options for getting out of it.

He could pay off his high-interest credit card debt with a low-interest bank loan or a secured line of credit. His interest payments will be reduced dramatically as he moves from credit card rates as high as 20% to an interest rate of prime or prime plus a small per cent. By reducing his interest costs, David can still make the same payments, if he likes, but now he'll be paying more in principal and less on interest, getting him out of debt sooner, for less.

For example, if David owed $10,000 at 20%, he would pay $2,000 in interest annually. But if he owed $10,000 at 4.25%, his annual interest cost would be $425. That's less than one-quarter of the cost in interest by simply moving his debt to a lower-interest line of credit or bank loan.

A COUPLE OF USEFUL GUIDELINES FOR USING CREDIT CARDS:

• first, only spend what you can afford
• second, pay off your balance in full each month

This approach should be considered each time you find yourself reaching for your credit card. A credit card can be a useful tool because it allows you to keep your money in your chequing account while you defer payment until the end of the month, as long as you pay the balance before any interest charges are applied.

FIXED VS. FLOATING
Now to Terri and Sam's mortgage dilemma. The fixed vs. floating interest rate debate for mortgages has gone on for years. And it's one that has die-hard supporters on both sides of the argument. Professor Moshe Milevsky, Professor of Economics at York University, conducted a study on the advantages and disadvantages of having a fixed vs. a floating or variable rate of interest. Prof. Milevsky studied five-year intervals over a 50-year period (1950 – 2000) and found that 88% of the time, mortgage holders would have been better off going with a floating rate and renewing annually. Even when interest rates are as low as they are today, he discovered that it's very difficult to predict the best time to lock-in.

One of the primary reasons why a floating-rate mortgage can work better than a fixed rate is that most banks charge a significant premium for this added rate security. For example, in early 2005, many banks had a prime lending rate of 4.25% yet their five-year fixed-rate mortgage was closer to 6.0%. That's a 1.75% premium over the prime rate on a 60-month (five-year) term. The prime lending rate would not only have to catch up to this 1.75% premium but, for every month the prime rate was lower, it would have to rise significantly above that rate premium in order for the fixed rate just to break even (see graph below). Historically, such dramatic spikes in interest rates have rarely occurred.

Terri and Sam should consider a floating rate for their mortgage if their goal is to pay the least amount of interest. However, first-time homeowners may want the peace of mind that comes from knowing what their mortgage payment will be. Locking-in to a fixed rate for a year or two may be a good way to establish this comfort level before they move to a variable rate.

GET THE MOST OUT OF YOUR SAVINGS
Sarah knows she wants to have access to the $10,000 she's saved but isn't sure she's getting the most out of her savings by leaving it in a bank account. She doesn't have many debts but is concerned about saving for retirement.

If Sarah takes her savings and puts it into a nonregistered investment, she can then use it as security for a line of credit. That way, her money is working hard for her instead of sitting in a low-interest bank account. With her secured line of credit, she still has access to cash when the need arises, at a low rate of interest. The end result: rather than having her money sitting there "just in case," Sarah is putting her money to work but hasn't lost the ability to access emergency funds if she needs them.

MANAGING DEBT AND EMERGENCY SAVINGS
Many consumers are now discovering that there is a way to combine David's solution of converting expensive debt into regular debt with Terri and Sam's solution of reducing interest costs using a variable rate on their mortgage to simplify their finances. And it can even incorporate Sarah's solution of putting her savings to work while maintaining accessibility. The answer is a "flexible mortgage account."

A flexible mortgage account combines the wisdom of the floating rate approach with the immediate savings of debt consolidation. By combining all of your debts (credit cards, line of credit, mortgage and personal loans) into one account at a low floating rate and having your income put into that account, you can save thousands of dollars in interest costs over the life of a typical mortgage. Then, if you take your short-term savings and your income and deposit them into your account, you reduce your debts, save interest and still retain access to that money if it's needed.

If you have a mortgage, look into this innovative solution – it could save you a whole lot of money. If you don't have a mortgage, investigate how you could use a line of credit to save on interest costs, invest for the future and still have emergency funds at hand.

WHAT YOU OWE TODAY MAY DETERMINE WHAT YOU OWN TOMORROW
How much you have tomorrow can be linked to how you manage your debt and savings today. Help yourself by:

• Saving interest costs today with secured lines of credit, floating interest rates and flexible mortgage accounts
• Investing for tomorrow, today
• Seeking the guidance of a debt counsellor to get back on track when you feel you have too much debt
• Speaking to your financial advisor, he or she can help you with both sides of your balance sheet

TIPS FOR "FISCAL FITNESS"
Here are a few tips for getting into financial shape:

• Pay off all credit card debt immediately, even if only by moving it to another, cheaper debt vehicle like a line of credit
• On a go-forward basis, pay credit card balances off in full at the end of each month
• Avoid financing from retailers since most retail credit card interest rates are even higher than most credit card rates
• Be careful of "Don't pay a cent" interest traps – the interest has already been factored into the price of the item
• Use any windfall money (tax return, year-end bonus, etc.) to reduce your debt, eliminating the highest interest debt first
• Switch from a fixed-rate mortgage to a variable-rate mortgage if you can absorb periodic rate fluctuations
• Leave your income in your bank account and use your credit card for all monthly expenses. Then, transfer money to clear the balance. You've effectively used someone else's money for free all month and you will have gained any rewards that are offered with your credit card