The big mistake in ‘managing’ debt

It’s a profound thing that RRSP season comes right after holiday-bill season.

As Canadians get set to deal with an average $28,000 in consumer debt, the finance industry launches an onslaught of ads telling us we’re richer than we think.

They know about our debt. They profit from our debt. Getting us to buy their investment products allows them to reach into another pocket and get more of our money. They even have a way to get more from both pockets by offering RRSP loans.

And it seems to be working according to a recent poll by RBC that finds Canadians are focusing more on savings than paying off debt. It says 52 per cent of respondents are increasing retirement saving compared to 44 per cent last year. Only 48 per cent are making debt reduction a priority compared to 54 per cent last year.

RBC concludes: “Canadians are more comfortable with how they are managing their debt.” According to industry-speak “managing debt” means servicing debt, which means earning enough to make regular payments. It does not necessarily mean significantly paying down debt or consolidating high interest debt into one lower interest loan to pay down more of the principal. A good chunk of consumer debt goes toward paying down credit card balances with interest rates in the high teens. Credit card companies and banks with a stake in credit card companies love that.

The finance industry can relax as long as our earnings keep a shade ahead of our regular debt payments. They’re rooting for us to earn more so we can keep spending to fuel an economy that relies on consumer purchases for two-thirds of all goods and services produced.

That’s why government and businesses get jumpy when the household debt to income ratio rises. According to Statistics Canada we owe a record $1.64 of debt for every $1 earned each year. The income/debt treadmill can only generate bigger profits if household earnings keep pace with debt. If the cost of servicing debt grows faster, it breaks down.

Savings and debt in harmony

The household debt to income ratio means little to individual households. A young family with a modest income and a big new mortgage, for example, could get by comfortably paying $3 for every dollar earned to invest in a home. Mortgages rates, which are in the low single digits right now, are among the lowest of any debt. In most cases household incomes rise over time and the balance owing on the house drops – eventually bringing the debt to income ratio lower.

When that time comes, savings and debt can live in harmony. Those higher incomes mean more money to pay down debt and save at the same time. They also put individuals in higher tax brackets, which means bigger refunds on registered retirement savings plan contributions.

Keep in mind your RRSP nest-egg is taxed when it is withdrawn; hopefully when you are in a low tax bracket in retirement. Contributing to an RRSP during your low income years is pointless if you will be withdrawing in the same tax bracket in retirement. The only advantage is the ability for your savings to grow tax free (in which case the government gets a bigger chunk of your retirement savings).

In any case, if you are paying down debt - especially high interest debt - there are likely no other investments that can guarantee a tax-free return equal to the amount of interest being charged.

To put it another way, investing in an outstanding VISA balance at a rate of 18 per cent is like investing in a Triple A bond that yields 18 per cent. Good luck finding that.