Every week I hear from clients who are in the following situation (or some variation thereof): They have a chunk of money set aside as savings and they’re adding to the pot every month. The problem is that they also have debt and they wonder if they should continue to save or use the money to tackle the debt. When they call me, their question is about saving the money as a down payment for a house rather than paying off debt.
My advice typically boils down to this: Tackle the most punitive debt first before thinking about saving, then ramp up your savings. What do I mean by punitive debt? Very simply, it’s the credit card debt that costs you a fortune in interest fees and that affects your credit score if your balance is too high relative to your credit limit. We tell our clients that their first goal is to get their credit card debt levels to below 35% of the credit limit. The ideal goal is to pay off the balance every month to avoid nasty, double-digit interest rates, but if that’s not immediately possible then target 35% as a great goal. If you have multiple credit cards, then tackle the one that has the highest amount owing relative to the credit limit (assuming all your credit cards charge roughly the same awful interest rates). It’s all about maintaining healthy ratios. When you get too close to your credit limit, your credit score begins to suffer. Lenders typically want to see that you have credit, that you know how to use it and that you’re not maxing out your limits.
One of the pitfalls of focussing entirely on debt is that it’s easy to get out of the habit of saving. There is a further danger once the credit card debt is all paid off, and that’s the temptation to start spending again now that you have all this room on your credit cards. Here is the approach we take with our clients:
- Pay off the debt asap. Find areas in your budget where you can save some money and divert all that extra cash to eliminating credit card debt.
- No new spending in the interim. If you can’t pay it off in full at the end of the month, then don’t buy or delay the purchase.
- Once you’ve paid off the credit cards, put every dollar that you were paying towards debt into a savings vehicle like a TFSA or a special fund for a down payment.
What about other debt? Is all debt bad? Absolutely not; some debt is considered good debt. Here are a few examples of good and bad debt:
Collections are never good for your credit score. We’ve already talked about credit card debt, but beyond that any collections on your file should be paid off asap. We frequently see disputes on file with common cellular and cable providers, and in every case our clients have a reason why the bill hasn’t been paid off. Usually the charges are being disputed. The problem with letting this type of debt sit around is that it has a derogatory effect on your credit score. I understand that it’s frustrating to have a charge that you feel is unwarranted, but ask yourself if it’s worth the cost to fight it. The stress and the impact on your credit score may not be worth it. If you’re planning to buy a house in the near future, you need to protect your credit score. So tackle your credit cards and any collections first. The sooner you get those under control, the better off you’ll be.
Lines of Credit
If you’ve used lines of credit for investments, then the debt may be considered productive debt because it was used to purchase assets and you can write off the interest. However, if the LOCs were used to purchase consumer goods or to consolidate debt from credit cards, then they should be tackled right after you finish paying off your credit cards and collections. They key issue with this type of debt has to do with what it was used for. To quote Robert Kiyosaki, author of Rich Dad, Poor Dad, if you’ve used the Lines to buy “doodads”, then get rid of that debt asap and avoid it in the future. If you’ve used the LOCs to buy assets, investments that will put money in your pocket, then it’s fine assuming of course that the asset is in fact making you money and you can easily afford the monthly payments.
Save now, Save later
Saving money is a habit, and it just happens to be a habit that is hard to form and maintain. It’s so easy to spend money when we have it, isn’t it? That’s true for everyone. In our Rent to Own program, our clients save money towards their down payment every single month as part of their rent. When the term is over, we encourage them to keep going with the “forced” savings. Why break such a good habit? This is the same advice we give to everyone: Act as though you as are saving for another down payment. You are in a way: once you’ve got a house your next down payment is for your future rather than a piece of real estate. That should be worth some effort!
If you’re looking for a great argument about the benefits of saving a bit of money sooner rather than later, then I recommend that you read the book I will teach you to be rich by Ramit Sethi. He presents a well-known argument with well-known examples (e.g. one penny doubling every day for 31 days) but he has an amusing, compelling style. He also shows you step by step how to automate your savings.
So the upshot on my original question is this: Slay the credit card monster and save, save, save.