Debt Repayment & Interest

On July 11th, the Bank of Canada raised the
interest rate by a quarter of a percent. You may be wondering, “What does that have
to do with me?” Well, if you have any debt, you’ll want to
listen, because paying off your debt quickly is more important now than before. I outlined some tips for paying off your debt
in my previous video “Strategies to Pay Off Debt”. In today’s episode, I’ll show you concrete
numbers that demonstrate how making slightly different decisions will impact what you pay
overall. I’m Susan Daley and this is Your Money,
Your Choices. The Bank of Canada target overnight
rate moved from 1.25% to 1.5%. When the overnight rate increases, the prime
business rate – or the rate banks use to price debt – moves in lock-step. In my previous video – which you can watch
here – I pointed out that many loans are quoted as Prime + X%. On July 11th, prime increased from 3.45% to
3.7%, so variable debt incurs 0.25% more interest. For those who haven’t watched my previous
video, here’s a brief rundown of the basic guidelines:
Pay off loans with the highest interest rate first
Pay off the balance as soon as you have money available, rather than waiting for a lump
sum Pay back as much as possible above the minimum
payments to reduce the time it takes to pay off the loan. Let’s get into the example:
Gary is a recent university graduate. He received some funds from OSAP to complete
his chemistry degree but unfortunately, OSAP didn’t cover all his fees so he had to take
out a line of credit too. When he graduated, he moved to the GTA and
used some of his Line of Credit limit to furnish his apartment. At the same time, he bought a used car to
drive him from Mississauga to work in Toronto and took out a car loan to pay for it. Gary was offered a full-time position with
his final co-op employer which pays a salary of $50,000, with bi-weekly paycheques. Gary’s OSAP loan is for $7,500 and is a
variable loan of Prime + 2.05%, or 5.75%. His minimum payment is $85.50 per month. The amount of Gary’s car loan is $12,500
with a rate of Prime + 1.95% or 5.65% total. His minimum payment is $205.10 per month. Finally, his Line of Credit has a balance
of $15,000 at an interest rate of Prime + 4.5%, or 8.20% total. The minimum monthly payment is 1% of the loan
balance or $50, whichever is greater. With a balance of $15,000 his first minimum
payment is $150. In total, Gary has $35,000 in debt. Paying only the minimum payments, Gary will
incur the following amounts on his loans: The total payments for all loans are $64,590.19,
which will take him 43 years to pay off. Or 516 months! Of that amount, $29,596.19 of what he pays
will be interest. Yes, that means that Gary will pay almost
double his current balance because of the interest. Oh, and this is assuming that interest rates
don’t increase. So, as you can see, it’s important for Gary
to pay off those loans as quickly as possible. The first strategy is to apply the debt avalanche
method, paying off loans with the highest interest rate first. Right now, the line of credit has the highest
interest rate at 8.20%. The next highest is the OSAP loan with an
interest rate of 5.75% and behind that, the car loan at 5.65%. However, we need to consider something else
when looking at government student loans. You can claim a tax credit on your tax return
for the interest you paid on the loan whereas bank student loans don’t receive this tax
credit. In Ontario, Gary gets a 20.05% tax credit
on his OSAP interest. We can reduce the corresponding interest rate
by this credit, so the OSAP after-tax interest rate is 4.60%. This means the order changes to paying off
the Line of Credit first, then the car loan, then OSAP. OSAP loans are also eligible for Repayment
Assistance if you become disabled or simply don’t earn enough to pay back the minimum
payments. If the rate on your OSAP loan is higher, it
may still make sense to pay off other loans first since the government has these repayment
options if you run into financial trouble. Now that Gary is putting 20% of his after-tax
income towards debt repayment based on the budgeting guidelines in my “How Much Should
I Spend Each Month?” video, $700 per month is going towards his
debts. Gary will pay the minimums each month, and
put an extra $259.40 towards the Line of Credit until it’s fully paid off. The loans will be paid off in 59 months (just
under 5 years) with a total of $5,924.53 in interest. If Gary used the debt snowball method instead
– paying the smallest balances off first – he’d pay an extra $836.52 in interest, lose out
on $235.04 in tax credits, and delay his debt repayment by a month. The second strategy is to accelerate your
debt repayment. In the first scenario, Gary puts the minimum
payment toward the loan each month and an additional lump sum payment of $778.20 every
three months, which equates to $700 per month. This results in total interest of $6,119.15
paid and the loan paid off over 60 months. The second scenario takes Gary’s $700 monthly
budget for paying off the debts and splits it into bi-weekly payments of $323.08. Making bi-weekly payments rather than extra
lump sum payments every 3 months saves $381.08 in interest and knocks a month off the time
to repay the loan. Just by setting a different frequency, you
save interest costs without changing the amount you put towards the loans. The automatic bi-weekly payments also make
managing the repayment easier. The final debt repayment strategy is to pay
off as much as possible (as quickly as possible). After sitting down with Gary and reviewing
his budget, we determine that he would be able to put $1,000 per month towards his debt
by cutting back on some of his discretionary spending. Since he’s getting paid bi-weekly, Gary
decides to set up an automatic $461.54 towards his debt every 2 weeks. He goes into his online banking three times
to change this automatic payment: once he pays off his line of credit, once his car
payment is eliminated and when he cancels the payment once his final OSAP balance is
paid off. Putting 30% of his after-tax income towards
his debt rather than 20% means Gary only pays $3,671.74 in interest costs and gets his debts
paid off in 39 months – that’s more than a year and a half earlier! As you can see, paying off your debt as quickly
as you can, while focusing on paying off those debts with the highest interest rate first
can save you thousands of dollars in interest expenses. Automatically setting aside money as soon
as you receive your paycheque will allow you to pay your debts off more quickly and get
you into the habit of saving money each month so you can start earning compound interest
rather than paying it. Have rising interest rates affected your debt
repayment plans or your ability to pay off debt? I’d love to hear about it in the comments below. Be sure to subscribe to my channel for more
information like this or connect with me on LinkedIn. I’m Susan Daley, and this has been Your
Money, Your Choices.

3 thoughts on “Debt Repayment & Interest

  1. Great video, it's nice to see Canadian financial advice. In your experience, how likely are people to stick to the plan? Across the various methods, debt avalanche, debt snowball, or accelerated payments, what one works best in the real world? There is some argument among some of the gurus about what method actually works best. If Gary paid off his OSAP loan first, he would feel immediate traction which may help motivate him to keep going. If starts knocking down the car loan or line of credit due to interest rate, will he become discouraged and quit altogether? I'm interested in your experience, which method works the best when human nature is involved? Keep up the good work!

  2. After six years of burying my head in the sand, in relation to my student loans, I finally decided to buck up and pay off a massive portion of my debt. I can almost literally weight being lifted off of me now. Lol. Great videos! I Love them ❤️

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