Escaping the cycle of debt

With the rising cost of living coupled with increasing interest rates, debt has become a pressing concern for many Canadians. Whether it's a line of credit, student loans, credit card debt, or other outstanding balances, the interest can accumulate quickly, trapping you in a cycle of debt. Compound interest can work in your favour when you invest money, as you’ll earn interest on both the original deposit and on the interest accrued over time. But, when you owe money, compound interest takes on a different, less favourable form known as negative compound interest. In this case, the interest continues to accumulate and compound on the debt, and as a result, the total amount you owe continuously increases, even if you make regular payments.

Understanding the advantages and disadvantages of paying off debt is crucial to your strategy.

Reduced stress and anxiety: According to FP Canada’s 2023 Financial Stress Index, nearly half (48%) of Canadians have lost sleep over finances, and one in three (36%) have experienced money-related mental health challenges. Constantly worrying about debt can take a toll on mental and emotional well-being. By paying off debt, you can experience relief and reduced stress, leading to improved overall happiness and peace of mind.

Interest savings: When dealing with debt, it's essential to be aware of accumulating interest charges, particularly in cases involving credit cards or loans with high interest rates. The Financial Consumer Agency of Canada (FCAC) provides a credit card payment calculator designed to help you assess the outcomes of three distinct approaches related to your balance. These approaches include exclusively paying the minimum monthly amount, combining the minimum payment with additional contributions, and consistently sticking to a fixed monthly payment.

If you only pay the minimum amount, you won't make much progress in lowering the original sum of money you borrowed or owe (the principal amount), and you'll end up paying a lot more interest over time. But if you pay more than the minimum or stick to a fixed monthly payment, you can reduce the principal amount faster and significantly reduce the interest accrued throughout the debt's lifespan, accelerating your path to becoming debt-free.

For instance, imagine you have a $1,000 balance with an interest rate of 11.69%. If you pay only the minimum payment — $30 per month  —  it will take 3 years and 5 months to pay off the debt and cost you an additional $157.69 in interest. However, if you increase your monthly payment by just $5 above the minimum requirement, you could eliminate your credit card balance 7 months earlier, resulting in interest savings of $37.36. Alternatively, if you consistently pay $100 each month instead of the minimum, you could potentially pay off your debt 2 years and 6 months ahead of schedule. 

Lower monthly debt payments: When you have less debt, you are required to make smaller monthly payments towards your outstanding balances.This reduction in debt-related expenses leaves you with more disposable income each month.

Ability to invest: Paying off debt opens up opportunities for investing. Instead of channeling money into high-interest debt, you can redirect those funds into investment vehicles that can grow your wealth over time, such as stocks, bonds, or Guaranteed Investment Certificates (GICs).

Credit score impact: Paying off debts on time can improve your credit score leading to better financial opportunities in the future, such as lower interest rates on loans and higher chances of approval for mortgages. However, when you pay off all your debts you may see a decrease in your credit score. It's temporary but that’s something to keep in mind. 

While paying off debt is generally considered a positive financial goal, there can be some tradeoffs to consider, depending on your specific circumstances and financial goals. 

Prepayment penalties: If you pay off some types of debt early, like mortgage debt, you could incur additional fees or penalties, negating some of the financial benefits of early repayment. 

Choosing the right debt payment strategy depends on individual preferences, financial goals, and circumstances.

Debt snowball: This method involves listing all debts from smallest to largest and focusing on paying off the smallest debt first while making minimum payments on others. Once the smallest debt is clear, its monthly payment is then put towards the next smallest debt, creating a snowball effect as each debt is tackled in succession.

The debt snowball provides quick wins and boosts motivation as smaller debts are paid off early, building momentum to tackle larger debts. However, by focusing on eliminating smaller debts first, rather than targeting the debts with the highest interest rates, you might accrue more interest over time. It's essential to weigh the psychological benefits of this approach against the potential long-term financial cost of paying more in interest.

Debt avalanche: With the debt avalanche approach, debts are prioritized based on their interest rates, starting with the debt carrying the highest interest rate. While minimum payments are made on other debts, the majority of available funds are directed toward paying off the high-interest debt. The debt avalanche strategy saves money on interest payments in the long run, making it a financially efficient approach.

Tackling debt when you're scrambling to make ends meet can be a challenging journey. Progress may feel slow, and the emotional toll can be difficult on your overall health, especially during tough economic times. That’s why it's essential to recognize that it's okay to take breaks, ask for help, and seek guidance when needed. Remember, as you consistently put effort into paying down your debt, your financial situation is likely to improve, and the weight of your financial burden will gradually lessen.

Ultimately, having less debt means more money in your pocket and more opportunities to invest for your future financial goals. The good news is that while you're working on eliminating debt, you can still take steps to invest in your future. For instance, if your employer offers a retirement savings plan with matching contributions, it's a wise move to take advantage of it so you don’t miss out on potential growth opportunities. The key to managing your debt is to strike a balance between repaying debts and investing, which can be achievable with the right repayment strategy, discipline and support. 

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.