Debt has become big business

There was a time when paying down your debts was good, prudent financial advice that came from the banks, other financial institutions and advisors.  It seems times have changed as I am getting more stories of people who are encourage to take on more debt as opposed to less debt.  Maybe this is part of the reason debt has hit record levels.  Here are few of my favorite examples.

Why pay cash?

Larry was going to do some home renovations and being from the old school, he put money away every paycheque into a ‘renovation’ account and did not start the renovations until he had saved $25,000.  When Larry went into the bank to get a certified cheque to pay the first installment to his contractor, the 20-something customer service representative questioned his strategy suggesting that interest rates are so low, he should open up a line of credit to finance the renovations.  She argued that he could use his money for investments which could give higher returns than the 3.5% interest deal she could give him on the line of credit.  Larry was not happy with this advice.  He gave her an earful and suggested that his 52 years of wisdom could teach her a few lessons about debt and money.

The bank employee might have sincerely believed she was helping him with her suggestion but the fact remains, she did not ask him any questions about his finances.  If she did, she would have realized that he was in a financial postition where he did not need the money or want any extra investment risk.  Besides debt may be a reason not to have savings.

Extend the amortization

Melissa and Doug were expecting their second child and wanted a bigger house.  They did well on their first house because of the real estate boom.  They have a $300,000 home with a $200,000 mortgage.  They wanted to move to a $400,000 home in a better area with more space but did not have extra cash so their down payment would be the $100,000 equity from their existing home.  Although they qualified for the $300,000 mortgage, the payments would be considerably higher ($1,750 per month) than their current $1,100 per month payment.

The mortgage specialist at the bank suggested that she could help them make the house affordable by simply extending the amortization.  Moving the amortization from 25 years to 40 years made the payments more affordable at $1,425 per month.  Melissa and Doug felt this was manageable.  Was this really helpful for Doug and Melissa given their total interest costs increased by 75%?  Who was the real winner here?  Who made the extra $165,000 in interest?  Why is it that the government had to step in and disallow 40 year amortizations?  Do banks not know that 40 year amortizations are not prudent?

Leverage the house

It’s all too common to hear financial advisors preaching the merits of leverage.  Leverage is simply using someone else’s money to make money.  At 58, Sarah separated from her husband. For most of her life, her ex-husband handled all of the finances so she went to see a financial advisor to get some help managing her finances for her retirement.  Guess what this financial advisor recommended?

As much as the divorce was not financially productive, Sarah got to keep the house which was clear title.  The advisor suggested that the equity in her home was dead equity and she would help her retirement by putting the equity in her house to work.  She should take out a line of credit for $100,000 and invest that in to a portfolio of investments.  The interest on the loan on an interest only basis was about $415 per month but the interest would be a tax deduction and the true cost of the interest was only $282 per month after tax.  Surely, the investment would do better than 2.82%.  Leverage has risks but did Sarah really need to take those risks?  Was this advice really to help Sarah?  Or was it really a commission creator for the advisor?  Had the advisor run a retirement plan instead of a leverage illustration, he would have found out that Sarah had a good pension through work and there was no need to take the extra risks.

Two ways to increase your wealth

If you look at the net worth statement as a means to measure wealth, there are only two ways to increase your worth and your wealth.  If you net worth is your assets minus your liabilities, then to increase your worth, you need to either increase your assets or decrease your liabilities.

Why is it then that liabilities keep increasing instead of decreasing?  Does some of this have to do with the fact that debt has become big business and really profitable business?  All I know for sure is I see and hear lots of stories of people who are encouraged and enticed to finance their purchases and take on more debt.  I know my credit card limit keeps increasing and I don’t have to ask for it.  I know that every week I throw away new offers for new credit cards and lines of credit.

What are your thoughts?  Do you agree or disagree?  Do you think the profitability of debt has something to do with the overall increase of debt in Canada?

Written by Jim Yih

Jim Yih is a Fee Only Advisor, Best Selling Author, and Financial Speaker on wealth, retirement and personal finance. Currently, Jim specializes in putting Financial Education programs into the workplace.For more information you can follow him on Twitter @JimYih or visit his other websites JimYih.com and Clearpoint Benefit Solutions.

14 Responses to Debt has become big business

  1. Great examples, Jim. No doubt debt is profitable for banks. The question we should ask ourselves is not ‘can we afford it’, ‘but should we’.

    For the thirty-something generation raising young children, there is little choice but to take on debt, whether it’s a mortgage on a home or LOC for other needs.

    But in the end, everyone is looking out for their own interest. The banks and CC companies are looking out for their shareholders. They don’t care if you should afford the $300k mortgage. If it’s profitable for them, they will do it.

    You have to look out for yourself through education and knowing where and how your money is spent.

    • Well said Bob! Don’t let the institutions tell you how much you can afford. Assess that figure for yourself. Too much debt creates short term fun but long term stress.
      Thanks for the comment!
      Jim

  2. I agree with Bob – there are some terrific examples here. Debt is expensive. If you can live free and clear of debt, you can use the money you’re NOT paying towards interest to save towards retirement or another goal. You may not be able to reap the ‘rewards’ of instant gratification, but believe me – you’ll be more gratified when you get to retirement and have no debt to speak of. http://www.solvingdebt.ca

    • Thanks Anna, I call it delayed consequence over delayed gratification. That’s the world we are in! Thanks for your comment
      Jim

  3. Thanks, Jim. Excellent thoughts.

    As a marketer, I couldn’t agree more that debt is profitable business.

    I must confess I thought of getting into the debt marketing business a couple of years ago, but I’m glad I didn’t. In many cases, additional debt is not the answer, and a disservice to the customer.

    Duncan

  4. I believe that, with interest rates as low as they are, this is an excellent time to take on debt. This assumes, of course, that one has the cash or cash flow to handle the debt… plus a darn good reason for taking on the debt in the first place. Bill

    • Thanks Bill. I think it’s important to see the other side. Sometimes articles like mine cater to the majority of people who have too much debt but certainly there are some people who are financially savvy and disciplined and know when taking on debt might work.
      Thanks for sharing!
      Jim

  5. The debt industry and the advertising industry have aided baby boomers to spend money which they don’t have for things which they really don’t need. However, blame must be shared by those who borrow and spend. Very few of us are innocent. Bill

  6. Looks like I make mistake as well, I posted it on another of your pages, heh what can I say, I’m a fan of having +10 tabs open… here is the 282 dollars per month making +3300 per year, just a detail and wondering why nobody noticed ! Just wanted to add that if invested in a 4% dividend, it is quite efficient since you save tax on the loan, and dividends giving +4% will be more tax-effective, not considering growth of the stock, so you can either use dividends to pay the loan for enhanced cashflow, or sell the stocks when rates go up, less transaction fees or waiting if you are in the red, which should not happen if you took a bank stock

  7. This is the reason we are cash flowing our wedding. We don’t want to be paying it off for years and years just because we can afford the monthly payment. We don’t want a life surrounded by monthly payments.

    It seems like banks will only “offer solutions” that increase their bottom line.

    The only time a bank every made me a deal was to keep my business. When I was buying my condo (a bank owned foreclosure) the bank that held the title offered me a loan that included only $500 for origination fees. I was originally working with and had been pre-approved with another bank because they gave me a great interest rate. I asked for the other banks offer in writing, turned around and handed it to my loan officer at my other bank and told him to match it or i’d walk. All of a sudden they cut $500 off my closing costs on the spot to keep my business… The “nonnegotiable” origination costs were suddenly negotiable again… hmmmmmm

  8. My husband and I are debt free, with 2 small children. Many of our friends are spending, vacationing, RV’s, new houses, etc. My husband often laments ‘how do they do it’? How can they afford it? I simply tell him, look at how much we could have if we spent the savings we had, plus the amount our house was worth? Man, we would be living the high life, but a slave to our jobs, and lose our freedom to go part time if we want to, pay for alternative healthcare options if our children need it, etc.
    People like instant gratification, but will be crying on everyone’s shoulder when things get bad and they need something, or can no longer afford what they have and lose it all. I worry, because government will try keep the majority happy, and if the majority are in debt, I can see them using our tax dollars to bail all these people who haven’t taken the time to think through their finances, and man I would be mad, having not taken advantage of living like they do, and then having to foot the bill anyways!

  9. Hi, Jenny… Regarding the two contrasting philosophies — frugality vs. spending liberally, a thought comes to mind — the older I get, the more I believe that the operative word is “balance.” Depending on one’s inclination, their interpretation of that word will differ. Still, we each need to find the balance point with which we’re comfortable. Bill

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