The single biggest mistake when trying to control and pay down debt is failing to eliminate the highest-interest debt first. You have to prioritize by two factors: the rate of interest being paid and whether or not it’s tax deductible. Credit-card debt for consumption purposes is the most pernicious because a) the interest rates are onerous at near 20% a year; and b) there’s no way to deduct the expense of this interest from your taxes.
Given this, the obvious conclusion is to pay off high-interest, non-deductible credit-card debt ahead of all other debts—ahead of student loans and ahead of mortgage debt, both of which usually involve much lower rates of interest.
The second biggest mistake is paying off non-tax-deductible debt ahead of valid tax-deductible debt. You may ask what debts ARE tax deductible? Well, if you are a business owner you may have a corporate credit card you use exclusively for valid business expenses that should therefore be deductible from business income: valid auto expenses, office supplies and equipment, various professional services and the like.
It’s better not to incur credit-card debt at all but other things being equal, you’d want to prioritize the pay-down of your personal non-deductible credit-card expenses ahead of corporate deductible expenses. Even if you’re a salaried employee, you may also be an investor who believes in leverage: borrowing money to add to your stock portfolios in taxable accounts. This debt is also usually tax-deductible.
It’s important to know the difference between debt with tax relief and debt that is not. Consider homeowners who take out a first mortgage to buy a rental property as an investment. The rental property often ends up with less debt than the principal residence. The winners are the bank that lent you the money and the income tax people. The interest expense paid on debt secured by your principal residence is not a tax write-off, but it is if you secure the loan with a rental or investment property.
Unfortunately, unlike the United States, Canada mortgage debt on your principal residence in Canada is not tax deductible, unless you are in one of those complicated schemes like the Smith Maneuver. Sandy Aitken of M-link Mortgage Corp. has written an entire book (Mortgage Freedom) that describes how you can restructure your affairs to do this.
“Simply put, if you are in the highest tax bracket and your loan interest payments are tax deductible, you will get more than half your money back,” Aitken says, ”If you borrow money to invest in the market or in a business or property that will generate income, then the loan interest payments are likely going to be tax deductible.”
Given that, Aitken says the biggest mistake Canadians make is that they tend to save and invest their own money, while also borrowing to spend on credit cards. “Never borrow to spend! Borrow money to invest – and use your own cash to spend!”
Doug Hoyes, of Kitchener-based Hoyes, Michalos & Associates Inc. (bankruptcy trustees), says the biggest misstep we make when dealing with debt is not realizing the best way to eliminate debt is to stop incurring new debt. “Continuing to use credit when you have balances you can’t pay is mistake number one. If you have credit-card debt, stop using those credit cards now! Paying down one debt while incurring more debt is generally a mistake.”
A related error is borrowing to make payments. “Getting a cash advance on your credit card at 19% interest to make your 5%-interest car loan payment is not paying down your debt; it’s making it larger.”
Even worse is using short-term payday loans to service debt—a phenomenon that’s been on the rise.
Hoye’s firm issues an annual study of Canadian debt called “Joe Debtor.” The 2019 version found 39% of people who become insolvent have payday loans—compared with 37% in 2018, and 18% in the 2015 study. The debtors in the 2019 report had accumulated an average of 3.6 payday loans with total amounts owing of $5,760.
Another mistake is attempting to deal with overwhelming debt on your own, instead of consulting a professional. “If you have more debt than you can realistically deal with over the next few years, professional advice is essential. Work with a credit counsellor or bankruptcy trustee to devise a repayment plan that actually eliminates debt so you can get a fresh start.”
Hoyes says that while many debtors believe they must cash in RRSPs to deal with debt, a professional can accomplish the debt elimination while keeping RRSPs and other assets intact.