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Debt: The Biggest Threat to Financial Planning and a Cancer to Cash Flow

By Cora Pettipas, CFP

The Problem

Debt accumulation is a cancer to individual wealth and is currently the biggest threat to financial planners. Why? Because before you can do any proactive financial planning with a client, they need to have a positive cash flow. For clients, debt is easily available, easy to accumulate and normalized by our society. As one of my clients once said to me; “You are going to be in debt your whole life anyway; you might as well enjoy yourself.” I have also heard numerous justifications for overspending from other clients when doing their cash flow analysis. My favourite is “Well, you only live once; you might as well enjoy yourself.” My answer to this is: If you only live once, why would you want to be in debt? Debt is slavery. It encroaches in on future cash flow and future life choices for current consumption. Why would clients want to leverage their future?

The basic traditional life cycle theory of financial planning suggests that in the early stages of career progression, the client buys a home and other durables like furniture. They may also start a family, and have educational costs associated with their new career. Later, as the client’s income catches up and surpasses their needs, they start paying down their debt and saving. It sounds like a reasonable model, except it does not work this way. The great depression generation, whom as a group, are a joy to work with because they are savers, never acquired a mass amount of debt like the following generations have. They tended to pay as they went, mainly because they had lived without some necessities in their early years and felt the importance of a nest egg. Secondly, because the easy and accessible credit we currently have today was not available during most of their lifetime.

Overview

Canadians’ carrying costs of their debt is at a historical low; with the policy interest rate set by the Bank of Canada currently at 1%. During this time of low rates, the debt income ratio for Canadians recently reached a historical high of 165%. Currently the most popular form of debt acquisition is the secured line of credit, which currently costs approximately 3.5 to 4.5%. These rates lull people into a false sense of affordability as the client looks at a nominal $333 monthly payment to service a $100,000 line of credit as completely affordable. This explains the historical increases in debt accumulation in Canadians reported by the Bank of Canada. The 30 to 50 age range still has the highest amounts of debt as a group, but the higher age cohorts are increasing in debt the fastest. I am using Canadian statistics and sources for this article, but they are similar in all developed countries.

This life cycle approach is broken, the main reason is now most clients will acquire a heavy amount of debt early in the life cycle, and continue to carry it, and even increase it, into their higher income earning years. To add to this issue, the regions with higher average incomes also have the highest debts. When people make more money they now have more, not less debt! Therefore, as a financial planner it is important to be cognizant that the solution to helping clients decrease their debt loads is not just more income. From my experience, when a client has a pay increase of $1, they spend a $1.10 more.

The Solution

Financial planners need to be keenly aware of this debt threat to their client’s financial health and wellbeing. They need to illustrate to clients what debt does to future cash flow and household net worth. We have traditionally divided debt into ‘good debt’ and ‘bad debt.’ Good debt being home acquisition or education debt, for example. Bad debt being consumer discretionary spending. The lines of these kinds of debt are being blurred, especially with the increased trend in secured line of credits, otherwise commonly known as people using their homes as ATMs. Good debt should be simply defined as anything that should increase your future income; and bad debt anything that increases your future expenses.

  1. Match Cash Flow Analysis with Life Goals. Planners need to address the client’s needs and wants, and tame the unbridled society driven thirst of acquiring more. Clients need to understand if they stay tethered to keeping up with social pressures; their financial situation will always be mediocre at best. I would suggest presenting your clients with a cash flow analysis along with their stated life goals. This is a powerful way of demonstrating to a client if their priorities and actual spending are misaligned.
  2. Educate on the Real Costs of Borrowing. Most clients are unaware that mortgages are amortized like an annuity having the interest front end loaded. For example, a client can currently acquire a 1/2 a million dollar mortgage at 3%, for a 30 year amortization. The monthly payment will be $2,103. They will pay $70,562 in interest costs in the first 5 years, or 27.5% of the total interest costs of $257,083, over the entire amortization (if the rate stays the same). This is why clients that keep refinancing and extending the amortization are doing a disservice to their wealth.
  3. Insure Your Clients are Aware of Interest Rate Risk. In a historically low interest rate environment like this, the cost of servicing personal debt will only increase. This is why clients are seduced into acquiring debt in low interest rate periods, they think in terms of monthly payments and not ever actually paying off the debt. This same mortgage in the above example at 7% instead of 3% would have a term cost of $167,733 a 38% increase, and an amortization cost of $685,483, a 67% increase in interest costs.
  4. Give Clients the Tools Needed. Lucky for us there are a lot of tools and resources that you can give clients to increase their financial literacy. They will still need you, but sometimes the best learning is through practise. Two Canadian debt related blogs that are fun to read and informative are Gail Vaz Oxlade and Greaterfool. Showing them links to calculators that they can play with is also helpful. I like this mortgage calculator and these cash flow calculators. Ultimately, any tools you share with your clients should be simple, empowering and lack a lot of implicate assumptions in the calculators.

Clients need to be empowered to believe that there can be life after debt, and that they do not need to be in a dependent state of spending future cash flow today. As a financial planner, it is an essential task to emphasise that by exceeding their consumption means today, they are hurting themselves in the long term, and setting themselves back years and possibly decades on their personal goals. If they want to make the most out of their lives, don’t they deserve to live debt free and have financial security and longer term financial independence? Of course they do.

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