Pay off your debt.
That’s really all I have to say about this topic. I can explain my reasoning for those who need a little convincing.
In an earlier blog I mentioned my preference for reducing expenses rather than increasing income. There’s nothing wrong with increasing income. I’m all for it. However, I really like my time off so decreasing spending is a way to spend less time in the office or at the job site. A relatively easy way to decrease expenses is to not pay interest on your purchases. Interest on debt is an expense with no material return. It’s money you spend and get (almost) nothing for. You do get a thing sooner rather than later, but at a cost.
A few years ago a co-worker, who made just as much money as me, bought a car. He went to a used car franchise with “on site” financing. The car he bought was not super expensive, $5,000, but they gave him a 5 year loan for it with a 28% interest rate. This gave “Easy Payments” and increased the final price of the car to about $8,800.
I’ll say this another way which I hope will make it clearer to some folks:
My co-worker and I made $32 an hour. We took home about $25 an hour after taxes. That means that he had to work for 200 hours (5 full weeks) to pay for the car. Then he had to work another 152 hours (just about 4 more weeks) to pay for the “Easy Payments.” That’s 152 hours of work for which he got nothing more than he already had. You could think of it as him working 4 weeks without getting paid for it, because that’s how it looked to his bank account.
This is the same pattern that many sellers of credit will use. “Easy Payments” in exchange for increased cost to you. In general, the easier the payments the longer you’ll take to pay off the purchase. The longer you take to pay it off the more it will cost you in the end.
If my co-worker had less debt at the time he may have been able to get a bank loan at 10%. That loan would have cost about $900 rather than the $3,800 he paid. Better yet, if he’d had the money in the bank to just buy the car he could have saved the full $3,800 cost of the loan.
“Then shouldn’t I be saving rather than paying debt?” you might ask.
Don’t get me wrong. Saving is great. I encourage you to do it. Just not at the expense of carrying debt one day longer than you must. Pay off debt first. The simplest reason is because interest on debt generally adds up faster than interest on savings.
Example: $1,000 in a GIC might pay $40 interest in a year. If, at the same time, you carry $1,000 on a VISA or MasterCard it will cost about $220 in interest. Saving that $1,000 will make you $180 poorer by the end of the year. In Finance Speak that difference would be a ‘net loss.’
Worse than that, if you have the GIC in a Non-registered Account you’ll have to pay income tax on it. You’ll probably end up with just $30 after taxes. At year’s end you’ll be $190 poorer. Also, some card companies will increase your interest rate if you carry a balance for a few months thereby charging more from the people who can least afford it. The poor get poorer.
It might feel good to see money in your bank account but it can cost you in the end. Save only your Emergency Fund then get working on debt repayments.
Whether you pay off your smallest debt first (snowball style) or your highest interest debt first (avalanche style) is up to you. Just pick one and start there.
A couple of other reasons to pay down debt are because it makes you a ‘better credit risk’ and it frees up space to borrow. Not that you should re-borrow after paying off a debt.
The eventual goal of your financial plan should be to get into a position where you never have to borrow money again. Where you can just buy the things you need and not worry about making payments into the future. But near the start, if you aren’t in that position yet, you may have to borrow – but only for the things you need, never borrow for what you could do without.
These days a lot of people seem concerned about Credit Scores. In the olden days of my youth it was only institutional lenders that were interested in such things. Now I hear of landlords and prospective employers asking after Credit Scores. Paying your bills regularly, on time, and paying your debts off will greatly improve your Credit Score.
If your Emergency Fund is weak (like $500) and you haven’t started your Hard Times Fund but you have been paying down your debts, during an emergency you might be able to re-borrow at a lower interest rate than you were previously paying.
Now I hear you ask, “If it’s better to pay debt than save money why have an Emergency Fund at all?”
The answer is, “Because the Emergency Fund is for small emergencies.” A bank, with its lower rates, is unlikely to lend you $500 or $1,000. If you need to borrow that amount of money you’ll be looking at a cash advance on a credit card or a payday loan. Credit cards frequently have cash advance fees and higher interest rates than for purchases. This makes them a poor choice for borrowing. And you should never, EVER borrow from a payday loan place. I personally would rather go to the States and sell my blood.
Debt today means a poorer tomorrow. Pay that stuff off now! Build a better future.
Check out “CBC Marketplace Payday Loans” on Youtube
https://www.youtube.com/watch?v=Ea2-qytKw6Q
if you like (financial) horror movies.
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