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Caught in a debt web? Simplify and consolidate

Dale Jackson

Psst. Wanna make an easy $6,500? It's guaranteed, risk-free, with no strings attached.

If the offer seems too good to be true, it's not if you're carrying high-interest debt. That's about what it costs in interest over three years with a $5,000 balance on a credit card offered by one of the big retail chains. The problem is; it's the credit card issuer getting a sweetheart deal at your expense.

Here's how it breaks down: A typical interest rate on balances owing at the big retail chains is 28 per cent. Interest on a $5,000 balance compounded monthly is $1,600 after one year, $3,700 after two years and $6,470 after three years. And that doesn't include fees.

Even when you do the math on Visa or MasterCard balances, which charge interest in the high teens, it's the kind of return that makes investment banks drool.

Yet according to the Canadian Institute of Chartered Accountants 43 per cent of Canadian credit card holders regularly pay interest on their balances.

Why we love high-interest credit

In an age when the benchmark lending rate for the Bank of Canada is one per cent, it's hard to believe any business would have the nerve to impose such high rates. It's harder to believe that any reasonable, clear thinking adult that qualifies for credit would agree to be gouged that much.

There are two factors working in favour of the credit card companies. The first is the propensity for the general public to be less affected by percentages than dollar signs. As an example, ten per cent on a $10,000 loan seems reasonable but compounding it monthly over a year and paying $1,047 seems steep — and it's the same thing.

Players in the multi-trillion debt market who understand the power of percentages can make millions overnight on a sliver of a percent.

The second factor is the ability for credit card companies to play hide and seek with the true rate despite recent government efforts to force more disclosure.

The credit marketing blitz of the past decade has further added to the smokescreen to the point where many consumers have debt from multiple sources - credit cards, car loans, student loans, retail payment plans, mortgages - with a variety of payback rates.

How to get out of the debt spiral

If you're one of the people caught in a debt web two words can set you free: simplify and consolidate.

First, you need to know what you owe. Make a list of all debt and corresponding rates of payment starting with the highest. If you are paying more than 10 per cent on any loan consider selling any investments you have outside a registered retirement savings plan (RRSP). There's no way you can get more than 10 per cent on any investment without taking some sort of risk, so your best investment is your own debt.

Next, talk to your bank about a consolidation loan to pay off the most expensive debt. The rate of interest depends on the financial institution and your credit rating but even a typical consumer loan of 10 per cent can make a huge difference.

Using the same $5,000 as a comparison, a 10 per cent interest rate compounded monthly over three years would generate interest of $1,741 — a fraction of the $6,500 interest at 28 per cent.

The power of a secured line of credit

The lowest lending rates most often come through a secured line of credit. A line of credit is secured when the borrower backs it up with collateral — most often equity in a home.

A secured line of credit usually corresponds with the bank's prime lending rate, which usually corresponds with the Bank of Canada rate. Currently the prime rate for most banks is three per cent and the typical secured line of credit is prime plus one — or four per cent.

At four per cent that $5,000 debt, compounded monthly after three years would be $636 — less than one tenth the interest at 28 per cent.

However, the Bank of Canada and bank prime rates are subject to change and lines of credit carry the risk of rising interest rates. Many banks provide options for consolidation loans that include locked-in term rates that are normally higher but provide security.

Some banks even permit lenders to roll their consumer debt into their mortgages, which would then be considered secured and attract a more favorable rate.

Rolling debt into a mortgage is also an effective way for borrowers to commit to a regular payment schedule. In any case, most financial institutions can set up a regular payment schedule for all types of consolidation loans so borrowers can target the day when they are debt free.