How to Live a Debt Free Life

How to Live a Debt Free Life

You’ve see it all over the news, “…consumer debt is at an all-time high.” This must be bad, especially if it’s on the news. You start to wonder about the $2,000 pair of skis (even though you don’t ski) you bought last winter on your credit card and still haven’t paid off. Was it such a great idea?… “But they were on sale!” Why do we get into debt problems and, more importantly, how do we get out of them?

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“Okay, just get the bare essentials. This is the last of our dough”

Don’t kick yourself too hard about the skis, you’re only human. The fact is it’s natural to want more stuff; it makes us happy, or at least we think it does.

I only made it to a few of my psychology classes in university (it was at 8am!) so I’m no expert, but when we think about buying something our brain is flooded with dopamine (happy hormones). This causes us to pursue those happy feelings and buy whatever item is on our mind. The problem is two-fold:

1) The item usually only provides short-term happiness

2) People are seeking instant gratification at the expense of their future well-being

Fuelling these problems even further is the “keepin’ up with the Joneses” mentality. It’s natural for us to look at our neighbors and compare our own possessions to theirs. We use them as a yard stick to measure our success and wealth. We think “Well, Jim got a new car and I must make more than him, so I should have a nicer new car”. The problem is Jim may have bought that car with 100% debt and will be working an additional five years into retirement to pay for it. Now you’re in the same sinking debt boat with Jim. The point is wealth is often hidden behind the houses, cars, and fancy clothes. Debt has been coined the “ultimate balancer” because it has the ability to make the average look like a millionaire.

Human nature is nothing new, but the increase in debt us consumers are taking on is at historical highs. Below are the ratios of debt to disposable income for the last 40 years posted by Stats Canada:

1970 – 80%

1979 – 83%

1985 – 70%

1994 – 101%

2000 – 115%

2006 – 130%

2014 – 164%

The 164% ratio in 2014 means that for every $1 of disposable income a person makes, they have $1.64 of debt. Debt includes mortgages and all other debt and disposable income is your gross income less taxes and other required deductions. In 2014 the average household consumer debt (debt excluding mortgage) was approximately $27,000.

A Bank’s Best Friend

Part of the reason for this increase is the ease in which we have access to debt today. Have you ever received a letter in the mail from your credit card provider saying you’ve qualified to increase your credit limit, even though you didn’t ask? The banks are banking that you’ll feel like you’ve earned that increase and use up some of that additional credit, which profits them via interest charges. The bank’s best friend is someone who is financially illiterate and will take on debt while sacrificing their long term financial well-being.

Interest rates are unbelievably low right now, which also increases the demand for debt. The prime interest rate in Canada today is 3%, whereas in the 1980’s it was as high as 20%. Part of this low is due to the economic plan of the Bank of Canada where low interest rates are used to stimulate the economy. So while you may feel very patriotic for taking on debt and helping out the economy, eventually these low interest rates will rise and you may find yourself in over your head.

In my next post I’ll discuss the best way to avoid getting into debt problems as well as what to do if your debt is already out of control.

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  1. Under what circumstances could we expect to see the prime interest rate go back up to that 20% level or even 10%?

    Also, image of Lloyd Christmas in the post AND Dumb and Dumberer coming out today? Savy.

    • Jonny

      I know, right?!
      I can’t imagine the prime interest rate ballooning above 10% in the near future (next 5 years) given the current economic situation. Doing so in a short period of time would be devastating to personal consumers and businesses alike. The Bank of Canada has hinted on raising rates in the upcoming year which could push prime to 4% or above in 2015. I think we’re decades away from another 20% prime rate.

  2. Is the debt to income ratio a monthly calculation? Like you mentioned, $1 of disposable income = $1.64 of debt, so would that mean that each person, on average, could possibly have $1,000 in disposable income, and have $1,640 in debt payments per month?

    Or is it that, I make $10,000 disposable dollars a year, and I have $16,400 dollars in debt?

    Thanks for clarifying,
    Erik recently posted…Staining My DeckMy Profile

  3. Jonny

    Hey Erik – it’s the latter in you comment – $10k in disposable income and $16.4k in debt.
    I found this to be shocking because you still have to eat and shelter yourself off that $10k, which means there’s not much left over to tackle debt.
    What happens often is a household becomes overwhelmed and they ignore their situation. Pushing them further and further into debt.
    Jonny recently posted…Family Financial Planning TipsMy Profile

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