The Debt Dance

I vaguely remember the economic strain my father faced as a young farmer in the early eighties in Alberta. It’s more the feeling of the situation that I recall than the situation itself, as I was born in the late 70’s. High interest rates and a few poor years of crops forced him out of farming, and eventually took its toll on his young family. My parents divorced while I was just starting elementary school. I remember the aftermath of the divorce, my mother stretching every penny she could, my father returning to school for retraining and eventually my mother returning to school to also retrain. While both of my parents succeeded in finishing their training and securing stable well-paid employment, it wasn’t until the end of the eighties before my father was back on track and my mother didn’t finish her degree until 1994. They put themselves through school with student loans that needed to be repaid. I graduated high school in 1996, there was no money for university from my parents, and their prosperity has been a relatively recent phenomenon. I had no sense of entitlement to a good life, I knew that if I wanted to succeed it would have to be on my own terms as a result of my own efforts. I also knew I could avoid many of the errors my parents had made.

My parents had too much debt. It may not have been too much debt when they bought the farm, but it quickly turned into too much debt when interest rates rose to absurd levels in the early 80’s. The amounts needed to service the loans and feed the family quickly exceeded their income, my mother got a job waitressing, but soon that money was also fully consumed by the need to service the loans, at absurd interest rates. There was little in the way of savings to fall back on to ride out the rough patch. A few more bad twists, and there was little they could do to stop themselves from losing the farm. There was no bailing out. The farm was foreclosed on, and our family had to move.

RULE 1: Have savings to ride out a rough patch, ideally 6 months of living expenses in a relatively liquid format. Look at your monthly payments, multiply them by 6, have that amount in your bank account or accessible to you on short notice at all times.

RENT/Mortgage: $2000
Car & Gas: $ 800
Utilities: $ 200
Food: $ 600
Other Debts: $ 200
TOTAL: $3800

Rainy-day Savings needed: $22,800

RULE 2: Pay high interest debt off first

Note, if your monthly living expenses are low, then you can get by with less in terms of a rainy-day fund. For example the other debts in this case were $0 and the car and gas was $400 as the car payment was eliminated, then the rainy day fund could be $3,600 less ($19,200). One of the best ways to reduce monthly expenses is to eliminate or reduce debts. I would suggest that once a sufficient rainy day fund is established, monies over and above what are needed should be spent on reducing debt, with the highest interest debt being the first to be paid off. Once the debt is managed, the savings can begin.

RULE 3: Don’t let the monthly payments fool you

Remember that every last penny of money borrowed must be repaid with interest. Sure the payments may be ‘affordable’ but do you really want to buy something for more than the sticker price? Let’s assume that you want to buy a car. You can buy a used car for $10,000 with your savings. Or you can lease a new car for $5,000 deposit and $5,000 down and $500 per month for 39 months with a $23,500 buy out. I know these are two very different things – one is an old car and one is a new car but let’s see who is in a better financial position at the end of the 39 months. Let’s assume that the resale value of the $10,000 car is $6,000 at the end of the 39 months. We’ll also assume that the person who buys the car outright saves $500 per month earning 3% interest, and that the person will use this money to buy another car outright at the end of 39 months.

At the end of the 39 months the leasor can either walk away from the car and get their $5,000 deposit back or pay another $18,500 to purchase the car. If the leasor buys the car (assuming additional financing is not needed), then he/she will have paid $48,000 for the car over the 39 month period. If the leasor does not buy the car they have $5,000 in the bank, but no car.

On the other hand the car purchaser has $26,455.46 available for the purchase of his or her next car. If he or she has a friend who is just getting out of their lease he/she can buy out the lease for $23,500 and still have nearly $3,000 in the bank.