Friday, July 22, 2022 / by Mario Daniel Sconza
Many Canadians are now facing a double whammy of rising mortgage payments as well as rapidly increasing prices for almost every item in the household budget. In order to make up for the shortfall, many of us seem to be going deeper into debt.
The latest figures from StatsCan back up this observation and show the main contributors to the ongoing rise in non-mortgage debt are credit cards and home equity lines of credit (HELOC). Last week we wrote about how to better monitor and control household spending, and this week we are going to look at the perils of not cutting back and using debt to finance that rising day-to-day household budget.
The first issue you are going to run into is the interest that will rack up on those debts. For the past two years, HELOCs have offered a very cheap and easy way to borrow a lot of money as interest rates hovered around the 2% range. In addition, rising home values also meant that banks and other lenders were pretty quick to give you more and more funds as the value of your house would easily cover the debt if it all went south.
Fast forward six months and things have now changed — a lot! Most home equity backed loans are on variable rates and they are now 1.5% higher than two months ago, and could be another 1.5% higher by the end of the year. If you borrowed a $100K for a kitchen remodel, a new ride, and a beach holiday, and consolidated those debts on an equity backed loan last year, you are now looking at an extra $3K in interest this year. If your mortgage is also variable, add another $2 or $3K to your annual payments for every $100K on the balance and you can see how quickly this is going to end up bad!
You should also be looking into the details of your home equity line of credit (there are many variations!) and make sure you know under what conditions the bank can cut off the flow of funds and how the balance is to be paid back. Banks have been pretty free wheeling with home equity loans as real estate prices surge and they have their butt covered, but this could change quickly if we see a sharp decline in real estate prices.
The other reason for the increase in non-mortgage debt was credit card spending. If you have to go into the red on your budget, just be aware that the average credit card interest rate of 20% is 4 or 5 times that of a home equity loan. It’s still a no brainer to pay off your credit card balance with a home equity loan if you have that option.
You also need to educate yourself on how credit cards work and avoid the jargon that credit card companies use to make you spend more or carry a balance. Have you ever received one of those letters from a card company telling you the great news that you have "qualified" for a credit limit increase? Sorry, it’s no reason to celebrate, especially if you are already carrying a balance. Accepting it may give some boost to your credit score, but maxing out the new limit while only paying 5 or 10 per cent of the balance (the minimum payment is just 3%!) is financial suicide!
"Low-interest" credit cards are another gimmick as most feature a not-so-low rate of around 10 per cent or offer a low rate that magically disappears after a few billing cycles. Whatever rate you have, make sure you do the math and see just how much interest you are paying. A $1000 balance on a low-interest card of 10% will still require 7.5 years of minimum payments to disappear (vs 12 years at 19.99%). Cash advances against a credit card are even more costly as interest accrues from the day of the advance and there may also be additional fees.
The latest ploy to get you to switch from one card to another is a balance transfer card. These can be a useful option, but only if you pay off the transferred balance before the interest-free (or low-interest rate) period expires. If not, fees, penalties and a much higher interest rate will all be triggered, and you are going to be worse off than before. Make sure to have a repayment plan in hand before you try the balance transfer option and read the fine print on the card agreement.
As household budgets get squeezed, it is easier than ever to rely on credit cards and home equity lines of credit as a source of additional funds. This is an expensive, stop-gap solution that will only temporarily kick the issue down the road. The only real solution is to monitor your expenses and continue to look at areas where you could cut back.
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