Whether you’re fresh out of college or further along in your career, it’s important to protect you and your family against a fluctuating economy. But how can you bulletproof yourself financially against the unknown?
As a bankruptcy trustee and consumer proposal administrator, I advise people who never thought they’d be sitting in my office. In many cases their financial problems started with an unexpected life event, such as a job loss, divorce or medical problem that impacted their income-earning ability. They used debt to survive and, when added to the consumer debt they were already carrying, they found themselves with more debt than they could handle.
Most people don’t believe anything like this could happen to them. But the truth is, it’s more common than you think. In fact, our experience shows that over a lifetime, one in six people will go bankrupt. Even if the consequences are not as severe as bankruptcy, you should try to set yourself up for success early, so you can handle whatever financial ups and downs come your way.
Based on my experience, here are my top five tips on how to build a strong foundation that will withstand any unforeseen life event.
Know the Real Difference Between Good Debt and Bad Debt
Conventional wisdom says that debt to purchase an asset, such as a house or an investment, is “good” debt, because you can use leverage to purchase a more expensive asset, and generate greater gains. Unfortunately the opposite is also true; debt magnifies your losses, so I have a different definition.
Good debt is debt that improves your life, and that you can reasonably repay even if your income decreases.
Before you take on a larger mortgage or an RRSP loan, crunch the numbers and be sure that you can continue to make the payments even if you have a temporary reduction in your income. If you’ve used debt to fund an investment, make sure you have a repayment plan that works even if the asset drops in value and you have to sell.
Have Access to Emergency Cash
Cash in the bank is the best insurance policy. If your income is interrupted, you can use the cash to continue making your payments. If that’s not possible, access to a line of credit also provides a financial cushion, but with significant risk.
The solution to debt is generally not more debt. Ask yourself whether or not you want to be reliant on debt to solve your financial problems.
Keep Your Lifestyle Debt-Free
If you have no personal debt, and money in the bank, you are essentially financially bulletproof. Being debt-free, in terms of funding your personal lifestyle, should be your goal. Avoid using credit cards to fund personal expenses. If you do borrow in your early years, make the payments hurt a little. Make the amortization period on any personal debt as short as you can. Debt repayment should be front-end loaded wherever possible. A seven-year car lease might have a smaller monthly payment, but a three-year car loan is better in terms of financial security.
Personal debt robs you of your financial freedom. With no debt you have no worries about missing debt payments. You can decide to change jobs or move tomorrow without restrictions.
Leveraging assets you own for the purposes of investing, or starting a business, should also be done with care and caution and with an eye on the “what if’s”. How much you can afford to borrow is not based only on the debt-to-asset ratio of the investment but on your ability to make the servicing payments under any circumstances.
Being debt-free is great, but if you co-sign a loan for a friend or family member, and that person defaults, you are now liable for the entire loan. That’s a significant risk. If you want to be financially bulletproof but still help your family member, write them a cheque. Give them a down payment, or loan them the money directly yourself. They may never pay you back, but at least the maximum you can lose is what you have already given them. Your risk is limited, and there can be no surprises in the future.
Have a Back-up Financial Institution
I also strongly recommend that everyone deal with more than one financial institution. At the most basic level, if you have debt, you should keep your excess funds on deposit at a bank different than where you have your mortgage or credit cards. If you ever have a cash flow crunch, you don’t want your lender to have easy access to your bank account. In some cases it is prudent to have two different credit cards, so that if one of your cards is compromised, you have a back-up card for emergency use.
Ultimately only you can protect yourself and your family. I’ll admit to looking at debt much more critically than most, but that’s likely because I’ve seen someone just like you in my office all too often.
About the Author: Doug Hoyes has extensive experience resolving financial issues for Canadian citizens. A Licensed Bankruptcy Trustee and co-founder of Hoyes, Michalos & Associates, he is also a Chartered Professional Accountant (CPA), Chartered Insolvency and Restructuring Professional and Business Valuator. He regularly comments on a variety of TV, radio and other media outlets on topics surrounding bankruptcy and writes a column for the Huffington Post. Hoyes has been a Licensed Trustee since 1995 and has testified before the Canadian Senate’s Banking, Trade and Commerce Committee in 2008.
Image courtesy of Stuart Miles – FreeDigitalPhotos.net