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 encouraged to take on more debt as opposed to less debt. Maybe this is part of the reason debt has hit record levels. Here are a few of my favorite examples.
Why pay for 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 position 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 to give 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 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 a 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 into 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 your 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? Do some of this have to do with the fact that debt has become a 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 in debt in Canada?