How to tell if you’re over-using credit—and get it under control

As a society, we’ve become comfortable carrying debt and making minimum payments on our credit cards, lines of credit and other forms of credit. Often, we don’t realize how dependent we are on credit until we reach our credit limits—and then discover how hard it is to manage our expenses without relying on credit. 

One of the best ways to determine if you’re at risk of future financial problems is to put your credit cards away; go cold turkey and stop using credit for three months. Why three months versus one month? It’s because you can mask your financial situation for one month by cleaning out your freezer or pantry, and curbing your lifestyle to get by. It’s a lot harder to do for three months in a row. If you want to try this self-test, you can choose to pay in cash or with your debit card; either is fine to use providing you are keeping track of your expenses.

You can make this test even more realistic by taking into account your total costs for irregular, seasonal and one-time expenses that come up during the entire year. These include things like car repairs and maintenance, clothing, vacation and annual insurance premiums. It may be that one or more of these expenses do not come up during your three-month test period, but you need to account for them in order to know for sure whether you really can cover all of your living expenses without leaning on credit. Once you’ve added up these expenses, divide the total by 12 and set this amount of your income aside each month in a separate account. The example in the table below outlines how to do this.

The person in the example above would set aside $500 each month in a separate account and use these funds to pay for their seasonal, irregular and one-time annual expenses.

Now, can you meet all of your living expenses, debt payments and set funds aside each month for your annual, seasonal and irregular expenses without using credit for the next three months you’re doing okay financially. If you’re finding it difficult to pay your bills on time and running out of money between paydays without using credit, it’s in your best interest to look at different options to regain control of your finances and get out of debt—but understand that it takes time to get into debt, and so it will take time to get out of debt. You have to take a realistic approach when looking at different debt solutions. With this in mind, here are a few to consider:

Debt consolidation

While you can’t borrow your way out of debt, depending on the amount of debt that you owe, your credit rating and overall financial picture, you may be able to consolidate your debt through your financial institution at a lower overall interest rate and monthly payment amount than you are currently paying. I recommend taking out a loan versus a line of credit or home equity line of credit since a loan has a set monthly payment and a fixed date when the loan will be paid in full. With a line of credit, the minimum monthly payment drops as the balance decreases, which means you will need to be disciplined and maintain your original payment—otherwise, it will take a longer period of time to repay it in full and you’ll end up paying more interest. It can also be tempting to use your line of credit for other purposes once you’ve repaid your original debt, and find yourself back in the red once again.

Liquidating assets

If you have savings on hand, it makes sense to use that money to pay down or pay off your debt, especially if you have a high-interest loan and credit card debt. I would caution you not to deplete your savings entirely, as it is important to have the equivalent of three months of expenses set aside in a savings account for emergencies. (Some people say they simply have a line of credit for emergencies, but if there’s a chance you’ll be tempted to dip into that “emergency” source of funds, risking your access to the money when a true emergency crops up, it’s best to avoid.) 

Credit counsellors are often asked if it is a good idea to liquidate funds in a registered retirement savings plan (RRSP) to pay off debt. Our perspective is that retirement savings are meant for retirement and need time to grow and provide you with a future retirement income. Your future self will thank you for not cashing them in. Funds withdrawn from an RRSP are taxed at source, which means you will need to withdraw 30% more than what you owe to cover off the tax requirement. Funds within a tax free savings account (TFSA) would be a better alternative for paying down debt, as they are not taxed when withdrawn. Before considering this option, you will need to validate that any funds in your TFSA invested in bond or equity funds have not declined, as it would not be a good decision to “cash out” when your funds may be at a lower value than when they were purchased.

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DIY debt repayment plans

You may have heard about the “avalanche” or “snowball” debt repayment methods. Both require you to make a list of your debts and then make the minimum required payments on all but one debt. With the avalanche method, you pay extra money on the debt with the highest interest rate. With the snowball method, you pay extra money on the debt with the smallest balance. Mathematically, you’ll save more interest through the avalanche method, but you may be more motivated to pay off your debt through the snowball method as you will see your smaller-balance accounts paid in full sooner. These are good solutions if you don’t qualify for a debt consolidation loan and have sufficient income to manage your payments on your own.

Debt management programs 

A debt management program (DMP) is an arrangement between you and your creditors with the assistance of a credit counselling agency. I would strongly recommend using a non-profit agency that is licensed and accredited; their counsellors will review your overall financial situation and assist you in developing a workable budget. Where appropriate, they may recommend a DMP where they will consolidate your multiple monthly payments into a single payment that fits your budget. They will contact your creditors and obtain full or reduced interest relief to help you pay off your debt within five years or less. A notation that you are participating on a DMP will show up on your credit report and be reflected on your credit report for two years after completing your program. You will need to rebuild your credit rating afterwards. Here are five tips for doing that:

• Obtain copies of your credit reports Equifax Canada and TransUnion of Canada and check to make sure the information is accurate. If not, request the information to be updated. There is no cost to obtain a copy of your credit report.
• Apply for a secured credit card, which means you allow the credit card company to hold your funds in a savings account as security for the account. This will reflect as positive information on your credit report, and providing you manage the account responsibly the security requirement is typically removed after one to two years.
• Manage your bank account(s) responsibly and build up your savings, as this will be reflected positively on your credit report.
• Always pay your bills on time, as bills that fall behind for utilities or cell phone accounts can negatively impact your credit rating.
• Establish a good relationship with your financial institution and ask for their assistance in helping you to rebuild your credit worthiness over time.

Insolvency solutions

If a person is experiencing severe financial problems and is unable to repay all or a portion of their debt, they may be able to resolve their debt problems with the assistance of a licensed insolvency trustee (formerly known as a bankruptcy trustee). After reviewing your financial situation, the trustee may recommend filing a Consumer Proposal (CP) or an assignment into bankruptcy. Under a CP, a proposal is filed in the courts and an offer is made to your creditors to repay a percentage of your debts over a period of up to five years. A majority of the creditors representing a majority of your debt must approve the CP before it becomes legally binding. A personal assignment into bankruptcy is usually the last option to consider and it takes anywhere from nine to 21 months to be discharged once all conditions are met. Both of these options have a negative impact on a person’s credit rating and it can take a number of years to regain your creditworthiness.   

No matter which solution you choose to resolve your debt situation, you still have to be able to live and manage unexpected financial emergencies along the path to debt freedom. So take your time and get all the facts, and make sure all your questions have been answered first.

Scott Hannah is the President and CEO of the award-winning, non-profit Credit Counselling Society, which has helped more than 600,000 Canadians since its inception in 1996.