Back in my banking days, with the exception of mortgages, personal loans were the go-to mainstay of lending. Our promotional material stated, “we can give you a loan for any worthwhile purpose – vacation, wedding, appliances, new car.” (Please, don’t shoot this messenger – that’s the way it was.)
One of the most common reasons for getting a personal loan was to consolidate multiple debts.
With the advent of lines of credit and home equity secured lines of credit, personal loans – especially consolidation loans – are not that popular today. But, if you find yourself with multiple outstanding credit card balances and smaller loans you’re having a hard time paying each month, why not consider a consolidation loan which will convert your many debts into one more manageable payment?
How does a personal loan work?
A personal loan is installment credit rather than revolving credit (as in credit cards and lines of credit).
You borrow a lump sum of money at a fixed rate of interest which you pay back gradually by making equal payments over a set period of time.
The payments you make are a combination of interest and principal which will gradually reduce the amount you owe until the loan is fully paid off. You know in advance exactly how long it will take to repay the loan and exactly how much it will cost you.
Once you repay the loan it’s done – It doesn’t replenish itself when you make a payment like a line of credit does.
Unsecured consolidation loans have never been very common. If you have assets – car, non-registered stocks or bonds, or a GIC – to secure the loan you will get a much lower rate of interest.
Advantages of a consolidation loan
1. You will save money on interest charges. Considering that the average credit card interest rate is around 19.9%, a term loan charging half that rate will save you hundreds (or thousands) of dollars, helping you get out of debt faster.
2. You know exactly when you will be debt free. Don’t we all like knowing when we’ll reach our goals?
3. One fixed monthly payment to manage. That’s a lot simpler than having many payments and due dates.
4. Protect your credit rating.
Disadvantages of a consolidation loan
When a customer wanted to consolidate multiple debts, I confiscated and cancelled all (except maybe one) of their credit cards. Invariably, (once I was out of sight) more than half would reapply for new credit cards and ramp up their overdraft protection, spending their way into a new debt cycle and getting into the same situation as before.
Related: Debt avalanche vs. debt snowball
This type of loan will not work for you if you don’t change and control your spending habits. It will just put you on the consolidation loan treadmill, extending the terms longer and longer.
Final thoughts
If you must borrow (for a worthwhile purpose?) a good way to go is using an installment loan with a reasonable rate of interest. The larger the payment amount, the shorter the term, and the sooner the loan will be paid off.
A consolidation loan will pay off all your smaller balances. Payments that fit your budget will save you money and eliminate your debt much more quickly.
When central and southern Alberta experienced catastrophic flooding in June 2013 there were 32 states of emergency declared and over 100,000 people displaced throughout the region. Reports of price gouging at various retailers surfaced on social media; one story in particular claimed that an unscrupulous Calgary retailer was selling individual bags of ice for $20.
Given the urgency of the situation, and depending on your level of preparedness, what options do you have?
- Move on to the next retailer and hope to find an honest owner
- Go home with no ice and wait for the situation to return to normal
- Suck it up and buy the ice, grumbling the entire way home about how you got ripped off
- Hope for some kind of government intervention to protect you and other consumers from price gouging
- Borrow ice from a friend or neighbour who has plenty to spare
Priced out of Vancouver and Toronto?
Many prospective home buyers in cities such as Vancouver and Toronto act like a $20 bag of ice is a good deal; as if they don’t buy that over-inflated bag of ice now they risk having to pay even more for a bag of ice in a few years, or worse, not being able to find a bag of ice again in the future.
It’s understandable. Ice is better than no ice. And buying expensive ice today is certainly more tempting than the prospect of buying more expensive ice (or no ice) tomorrow. But here’s why a first time home buyer is crazy to get into the Vancouver or Toronto real estate market today.
The Real Estate Board of Greater Vancouver said the price of a condominium apartment in April 2016 reached $475,000 – up over 20% from the same time last year. Meanwhile a townhouse in the greater Vancouver area will set you back $608,600 – up 22% from last April.
Related: Why Vancouver’s real estate prices are so crazy
Just as frothy in the GTA, the Toronto Real Estate Board reports that the price of a condo-apartment went for $409,631 in April while a townhouse cost $537,934.
When we look at housing affordability, recent Statistics Canada data suggests that the price to income ratio in Vancouver is an eyebrow-raising 11.2 while Toronto’s is 8.2.
Median household income in both Toronto and Vancouver comes in around $76,000 – surprisingly below the national median of $80,000 (and a knock to those who say the best paying jobs are in Canada’s two largest cities).
Let’s bring out our first time home buyers; a couple we’ll call Jon and Dany who live in the fictional Canadian city of Vanronto.
Jon got his foot in the door at a start-up and makes $30,000 annually. Dany is a designer with a software company and brings in $50,000 per year. Together they have scraped together $25,000 for a downpayment. They’re tired of paying rent to a landlord they never see while all of their friends move into brand new apartments and townhouses that they bought on the outskirts of downtown.
Dany’s parents insist that renting is a waste of money. “Why pay someone else’s mortgage?“, her mom says.
Both Jon and Dany are still paying the last of their student loans. Jon also has a small credit card balance of $2,500, while Dany pays $250 per month on her leased Honda Civic. The couple decides to head down to the bank to see what they can afford.
The good news is that Jon and Dany can get in on the ground-floor (literally) of a lower-end condo-apartment. It’s not in the heart of Vanronto like where some of their friends ended up, but the neighbourhood is up-and-coming with lots of potential, and the subway is close by.
The bad news is that while they can afford to buy a $445,000 condo, they haven’t considered their other monthly living expenses – important ones like groceries, or gas for their slightly longer commute. The leftover $1483 might stretch them thin.
Related: How much home can I afford?
And what about saving? This couple worked hard to squirrel away $25,000 over the last few years. Will they still be able to set aside money for emergencies, travel, or a new car? What about retirement? Dany’s employer offers a generous matching program for their group RRSP plan that she has yet to take advantage of.
There’s a lot to consider beyond the bank’s affordability calculator when buying a home. Does it pass the real life ratio test?
Put together by Rob Carrick of The Globe and Mail, the real life ratio uses take home pay instead of the less useful gross income used by the banks. It encourages you to use other expenses such as insurance, daycare, as well as a percentage for home maintenance and upkeep.
“Use the Real Life Ratio and you’ll know what you’re getting into before you buy a house. You may decide you need to save a bigger down payment, buy a smaller house, live in a cheaper location or not buy at all.”
Jon and Dany pore over the numbers and find their real life ratio is at 88.74, and according to the guidelines, any number over 86 shows a financial stress overload. In short, it means this couple has less than 12% of their take-home pay left over each month to pay for food, clothing, transportation, entertainment, travel, and insurance premiums.
Admitting defeat, Jon and Dany head back to their rented apartment to mull their options. The most reasonable solutions seem to be staying put and continuing to rent, or leaving Vanronto for good and moving to a more affordable city in Canada.
Final thoughts
Wannabe home buyers in Vancouver and Toronto can easily get caught up in the euphoria of an overheated market. Sure, maybe their parents made a killing on the houses they bought 30 years ago, but maybe their colleagues overextended themselves to buy homes closer to downtown, and maybe some of their friends received gifted down payments from their relatives to get into the market.
(Some 100 people even camped out for two weeks just for the chance to buy a $500,000 condo).
Much like price gouging during an emergency, as long as you’re prepared you still have the option not to pay the over-inflated price and wait it out, or move to a more reasonable and affordable location.
Know a bad deal when you see one. Overextending yourself just to get a piece of the real estate action in Vancouver or Toronto is not just a bad deal, it could spell your financial doom.
Our hearts go out to the residents of Fort McMurray who earlier this week were forced to abandon their homes and flee the city as a massive wildfire continues to devastate the northern Alberta community.
The fire, which is said could double in size by Saturday, has sent 80,000 evacuees to nearby work-camps, hotels, and recreation centres in one of the largest fire related evacuations in Alberta’s history.
The Alberta government will be providing $100 million in emergency funding to those who were displaced – about $1,250 for each adult and $500 for each dependent – in addition to matching donations made to the Canadian Red Cross. The federal government announced it would also match donations made to the Red Cross.
Please consider making a donation to the Red Cross in support of the Fort McMurray wildfire victims.
This week’s recap:
On Monday I presented 11 model portfolios to help simplify your investments.
On Wednesday Marie looked at the troubling addiction of shopping beyond your means.
And on Friday I took issue with a newsletter that said 30 year olds were financially screwed.
Why investors fail
If you’ve followed this blog for a while you must have heard of the behaviour gap – the difference between investment return and investor return. To illustrate this point I wanted to highlight a story I came across on the Motley Fool site:
The best-performing mutual fund from 2000 to 2010 was the CGM Focus Fund (CGMFX), which returned more than 18% annualized despite a flat S&P 500. The fund’s outstanding track record would have turned $100,000 into more than $500,000 over those 10 years. The only problem? According to Morningstar, the average investor in the fund actually lost 11% annually over those same very successful 10 years. That is not a typo: The fund gained 18% annualized, but its average investor lost 11% annualized. You’re not crazy to ask how that is possible.
The answer is that many fund holders tried to time the market. For example, the fund soared 80% in 2007, so hordes of investors poured money into it in 2008 — only to see it fall 48% that year. That decline led investors to pull money out in 2009, taking losses soon before the market soared from its low. Investors were making emotional decisions based on recent events, changing their stance repeatedly, and as emotion would have it, at the most inopportune times.
All the more reason to find an investment plan that works for you and stick with it for the long term. Accept that for a period of time your investments might lag other strategies, and resist the urge to take action on that information.
Weekend reading:
Berkshire Hathaway’s annual meeting has taken on cult status as investors flock to Omaha, Nebraska to listen to Warren Buffett spin his folksy wisdom. Nelson from Financial Uproar made the pilgrimage to see the Oracle of Omaha in the flesh, stay in an overpriced hotel, and pick up some Berkshire swag.
Buffett used a good portion of his time explaining why investors would be better off ditching expensive money managers and consultants.
Here’s a good recap of the gospel according to Warren Buffett, courtesy of the Evidence-Based Investor blog:
“Supposedly sophisticated people, generally richer people, hire consultants, and no consultant in the world is going to tell you, ‘just buy an S&P index fund and sit for the next 50 years.’ You don’t get to be a consultant that way. And you certainly don’t get an annual fee that way.”
It’s not just Buffett who’s beating the low-fee drum. New research from Morningstar says that the expense ratio is the most proven predictor of future fund returns.
A nice story on the My Own Advisor blog about a reader who found success through passive indexing.
A new report released by the Fraser Institute claims there is no direct relationship between the rates of return earned in the CPPIB (Canada Pension Plan Investment Board) and the benefits received by eligible retirees.
Michael James answers a reader question about changing asset allocation towards a higher risk portfolio.
What about switching from TD e-Series funds to ETFs? Canadian Couch Potato weighs-in on this question.
Are Fort McMurray homes insured for fire? MoneySense investigates.
An outrageous story about how the federal government is gouging car buyers for money never spent: making dealerships collect taxes on ‘rebates’.
The Globe and Mail’s John Heinzl puts his dividend column aside to explain how to save thousands, and live longer too, by ditching your car.
Are Millennials doomed in a lower return environment? Ben Carlson explains:
“No one has control over the market’s performance over their lifetime, but you can control your personal savings rate and how you handle your biggest asset — human capital.”
The longest bear market wasn’t in 1929 or 2007 but started in January, 1973. Here’s the worst bear market that nobody ever talks about.
How TV host, speaker, and author Bruce Sellery invests his money.
This blogger’s personal budget has saved her thousands of dollars.
Bridget from Money After Graduation says the future you are saving for doesn’t exist.
Finally, Adam Mayers was busy at the Toronto Star writing these gems:
- One snowbird’s $35,000 travel insurance surprise.
- Canada’s stock markets are tiny in the global scheme of things, yet many investors refuse to leave home. Here’s why they should.
- In moments of crisis, the power of doing nothing.
Have a great weekend, everyone!