Know that nagging feeling that you’re always stretched thin financially? It may be a symptom of much more serious trouble down the line.
People don’t stumble into a debt hole overnight, said Scott Hannah, head of the B.C.-based Credit Counselling Society. In most cases, the path toward unmanageable debt problems starts as a barely perceptible downward incline. Over the years, this gets steeper and steeper, until you bump into a large unexpected expense and everything craters.
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This pattern boils down to two basic money mistakes, according to Hannah. One is what he calls “having a leaky budget.” The second is not having a rainy-day fund.
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The more common way to describe this is not living within your means. That, though, tends to conjure up images of people living extravagant lifestyles that are completely out of sync with their finances.
A much more frequent scenario is people who do have some kind of budget but not one that is air-tight, said Hannah. Most adults are well aware of their monthly bills, but what often goes unaccounted in the family budget are things like the cost of small car repairs and maintenance, he added. Even if you don’t get into an accident or experience a major breakdown, your vehicle will cost you more than just gas, insurance and parking – and you should include an estimate of that in your list of expenses.
“Perhaps you’re spending $200, $300 more than you take in every month. Over three, four, or five years, that can really add up,” said Hannah.
Another frequent source of financial leakage is small expenses like a cup of coffee, said David Gowling, senior vice-president at debt consultancy MNP. And no, we’re not talking about the stereotypical $8 elaborate latte. Even $2-a-day worth of store-bought caffeine is something you should pay attention to and account for in your budget, said Gowling.
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The other very common problem of people who are always broke is not having any money set aside as a financial cushion, said Gowling. If you’re living paycheque to paycheque and you bump into an unexpected expense, “you’re probably going to put it on your credit card or add it to your mortgage,” he said.
A lack of rainy-day fund is also what leads people to opt for the option that involves small monthly payments instead of the one that comes with the lower overall cost. It’s why people, for example, choose to rent their hot-water tank, which, in the long run, costs several times the price of just buying a new one, said Gowling.
And a personal slush fund is also what will keep you afloat if you or someone else in your family loses their job. According to a recent survey by MNP, only 27 per cent of Canadians feel “confident” about their ability to cope financially if faced with a layoff.
Even a dip in your income can send your finances belly up. During the oil boom in Alberta, for example, “people [got] used to being able to work as much as they wanted. When their overtime went away, many found themselves facing severe financial difficulty,” Hannah said.
The lesson here is that living within your means isn’t good enough. “You should be living below your means,” according to Hannah.
Along with a rainy-day fund, you should have life and long-term disability insurance, especially if you have young children, said Gowling. When it comes to life insurance, in most cases it should cover both parents, even if one of them doesn’t work, he added.
The reason most people are able to live with a leaky budget and no rainy-day fund is credit cards. If you make minimum payments, you might be able to fend off insolvency for years, but the interest rate on your credit cards will quickly become a major drag on your finances.
Home equity lines of credit (HELOCs) can further delay the hour of reckoning, according to Hannah. If your credit card debts are becoming too expensive and you own a home, you might be able to consolidate your debts using a HELOC, which carries a much lower interest rate. Unless you have a plan to get out of debt and have a proper budget, you’ll likely end up relying on your line of credit like you used to rely on your credit cards.
There was a time when the standard car loan was for four years. Now that’s become eight years. While that has shrunk the size of monthly car payments, it has also significantly increased the likelihood that you’ll want to trade in your car before it’s fully paid off, Hannah said.
“The car depreciates faster than you’re paying your loan balance, and now you have a vehicle that’s worth $16,000 and you still owe $19,000 on it,” he said.
Fold your outstanding balance into the loan for your new car and you’ve officially created a dangerous car-debt snowball.
We’ve all heard about the dangers of buying too much house. But falling into that trap is easier than you think. One common mistake young couples make is to think that because they used to be able to afford, say, $1,000 a month in rent, they can afford $1,000 in monthly mortgage payments. But that’s only a fraction of the homeownership costs they’ll face.
“A good rule of thumb is to add 40 per cent to your rental payment and that is what your own house will cost you each month. That means, don’t commit to a $1,000 mortgage payment if you can’t afford total housing expenses of $1,400 each month,” says the Credit Counselling Society.
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