As we all know, central banks are currently raising interest rates in order to bring down record-high inflation. One of the negative consequences of such drastic measures for households is that they raise interest rates on debts, such as lines of credit, car loans, and credit cards.
On the eve of a potential recession, after having endured the tribulations of a pandemic, financial strain on households is pushing into new territories across all income levels. This brings us to a fundamental question: what can households, rich or poor, do now to counter the effects of rising interest rates on their ability to pay down debt and continue investing?
Financial planning and budgeting are often a difficult topic for families, since they can bring up mixed emotions, depending on each person’s experience with finances. Strategizing to pay down debt is not only a mathematical endeavour, but also an emotional one. Some people may choose to reach an emotional milestone, rather than a logical, carefully planned out one, and vice versa.
In this article, we will thus discuss three effective and proven ways to get a hold of household debt. Some of these methods even have names that remind us of the good old Canadian winter currently at our door.
Debt Snowball
Imagine that your household has three types of debt to pay down. You have a $25,000 car loan at a 7.99% interest rate, a $10,000 credit card at a 19.99% interest rate and, finally, an $80,000 line of credit at a 4.99% interest rate.
The debt snowball method suggests that, to kickstart positive momentum on your debt-paying journey, you should begin with the smallest debt in terms of amount.
Of course, this method runs counter to instinct, but emotionally it can be quite liberating for people who may be frozen in trying to figure out how to bring down their debt level. Under the debt snowball method, you would pay down the credit card, the car loan and, at the end, the line of credit.
Debt Avalanche
The debt avalanche method is tailor-made for the more courageous people out there. As its name implies, the goal is not to create a small amount of momentum, but rather to bring down almost the entire mountain in a first attempt.
If we were to order the three loans mentioned earlier, the debt avalanche method would begin with the $80,000 line of credit, followed by the $25,000 car loan, and finish with the $10,000 credit card.
Although not for the faint of heart, this method provides a larger-than-expected relief in its first chapter, making those who embrace it feel like the debt journey is already almost over. Knowing that there are only two smaller debts remaining will often speed up the process.
Debt Consolidation
Finally, the last debt-reduction strategy we will discuss today is for the more rational people. Mathematics tells us that we should get rid of the debt with the highest interest rate first, and then move on to the rest.
One way of doing so is to consolidate high-interest-rate debts into a low-interest rate vehicle, such as, in the previous example, transferring the 19.99% credit card balance and the 7.99% car loan onto the 4.99% line of credit, effectively consolidating three debts into one.
The secret ingredient to be successful with this method is to also transform the consolidated line of credit balance into a personal loan, thereby switching to instalment credit, which limits a person’s ability to reuse the credit limit as soon as it is partially paid off.
In conclusion, paying down debt is never an easy process, especially in times of rising interest rates. However, just like wearing your favourite pair of boots, choosing a method that makes sense to you may make the journey a little bit easier.
These methods do not constitute personalized tax planning, and it is recommended to see an accountant or tax expert should you want to optimize your financial situation. The methods outlined here are only meant as a broad discussion to help you get a head start on a debt-payment journey.
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This report is for the purpose of providing some insight into Pembroke and the Pembroke funds. Past performance is not indicative of future returns. Any securities listed herein, are for informational purposes only and are not intended and should not be construed as investment advice nor is it a recommendation to buy or sell any particular security. Factual information has been taken from sources we believe to be reliable, but its accuracy, completeness or interpretation cannot be guaranteed. Pembroke seeks to ensure that the content of this document is correct and up to date but does not guarantee that the content is accurate and complete and does not assume any responsibility for this. Pembroke is not responsible for decisions or actions taken or made on the basis of information contained in this document.
