All parties must come to an end. The low interest rate party hasn’t completely ended, but the music is slowly being turned down. After seven years of historically low interest rates, the Bank of Canada has raised interest rates by a quarter of a per cent. If you have an outstanding loan, your monthly expenses just increased. With the Bank of Canada hinting at more increases in the next year, here are some steps to manage your debt:
1. Take an inventory of all your debts
Take note of all your outstanding debts. This could include credit cards, student loans, car loans, fine of credits, home mortgage and business loans (personal). You want to identify the following:
- What’s the interest rate?
- Is the interest tax deductible?
- Variable or fixed interest rates?
- Open or closed loans?
2. Prioritize your debt repayment
Once you have an inventory of your debts, repay your debt with the highest interest rate first. How do you know which one is the highest? Use the chart below to help you.
Focus your attention on the loans with the highest after-tax interest rate. Take into account whether a loan has a fixed rate, which doesn’t change when interest rates go up or down or a variable rate, which does change as rates fluctuate. Generally, variable rates are better in the long run when rates are stagnant or on the decline. Locking into fixed rates is better when interest rates are expected to rise. If you expect rates to increase, consider prioritizing payments on your variable loans since the rates on your fixed loans won’t be changing. If you are looking to borrow some money, ask your lender for both fixed and variable rates and compare which one would work better for you. You may have to pay more for a fixed rate loan. Consider the additional interest as a form of insurance so you can sleep better at night. Finally, take into account whether a loan is open or closed. Open means there is no penalty for prepayment, whereas closed means paying back debt sooner could trigger fees and penalties from the lender. It may make sense to pay down a closed loan first even though the interest rate on an
open loan is higher if the window of opportunity to prepay a dosed loan is only available for a limited time. An open loan can be prepaid at any time without penalty.
3, Convert non tax deductible interest into tax deductible interest
Your after tax interest rate could be cut in half if the interest is tax-deductible. In order to do so, the loan must be used to generate income. Here are some scenarios where you could convert non-tax deductible interest into tax-deductible interest:
1) Sell investments to pay down non-tax deductible debt, re-borrow the money and use it to re-purchase the investments which were generating income. You will have the same amount of debt as before and same assets, but your interest would be tax-deductible.
2) Use equity in your home to b arrow against your house and earn investment income. Your debt will rise, but so will your assets and payments against the loan will be tax-deductible. Please be aware of the risk involved.
|Debt||Interest rate||Tax deductible||After-tax interest rate *|
|Credit card||20%+||Maybe, if used for business expenses||9.29% to 20%+|
|Student loans (Government)||5.45% (Prime + 2.5%)||Tax credit||4.36%|
|Line of credit||2.95% (Prime) – 3.45% (Prime + 0.5%)||Maybe, if loans used to generate investment income||1.37% – 3.45%|
|Student loans (non-government)||2.95% (Usually prime)||No||2.95%|
|Car loans (Auto Manufacturer)||0-4.99%||Maybe||0% – 4.99%|
|Home mortgage (National bank)||1.95% – 5%||Generally no||1.95% – 5%|
|Business loans (personal)||2.95% (Prime)||Yes||1.37%|
*assumes personal tax rate at 53.53%
Consult an accountant prior to doing these maneuvers as specific and appropriate documentation needs to be considered.
4, Focus on your cash flow and adjust expectations
Both you and your spouse should sit down and make a budget. People generally only follow a plan if they are involved in making it, hence budgeting should be a family activity. Estimate what your cash outflows will be for the upcoming year including all debt repayments. Use the current interest rate you are paying and add one or two per cent to it. This gives you some wiggle room if interest rates do rise rapidly. There’s no harm in planning for higher expenses, there are consequences for not being ready when they come.
You don’t have to panic just yet; we are still at historically low interest rates. It will take time and a disciplined approach to chip away at the mountain of debt you have accumulated. It’s better to start now than wait until the party is really over.
This article was prepared by David Chong Yen*, CPA, CA, CFP, Louise Wong*, CPA, CA, TEP and Eugene Chu, BAFM, MAcc,CPA, CA of DCY Professional Corporation Chartered Accountants who are tax specialists* and have been advising dentists for decades. Additional information can be obtained by phone (416) 510-8888, fax (416) 510-2699, or e-mail firstname.lastname@example.orgemail@example.comfirstname.lastname@example.org. Visit our website at www.dcy.ca. This article is intended to present tax saving and planning ideas, and is not intended to replace professional advice.