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Managing debt 101

The Globe & Mail / February 2023

Snowball vs. avalanche, consolidation, bankruptcy and more

Debt, says Toronto insolvency trustee Steve Welker, is like quicksand. “You dip your toe in just a bit, you’re fine for a while, then your car breaks down or you lose your job, then suddenly you’re spiralling downwards.” If this nightmare feels in any way familiar, here’s how to stay calm, stop the spiral and pull yourself back out.

How do I know if I’m headed for a debt crisis?

Debt management experts agree there is no precise threshold for having too much debt, but it’s a safe bet that if you are constantly making only minimum payments on, say, your credit card bill, or if you are behind on your phone bill or hydro bill because you can only pay one or the other, you are likely headed for trouble. If you start dodging calls from collection agencies, you are certainly in trouble. That’s when an unexpected emergency can tip you into a full-blown crisis.

“Usually someone will come in to see me because, although they have very likely been financially struggling for a while, some kind of event has happened that causes them to seek professional help,” says Gusharon Singh, a client experience manager with Credit Canada, a non-profit credit counselling agency. “Maybe it’s job loss or a health issue, but something’s happened that suddenly made the problem significantly worse.”

One thing you definitely shouldn’t do is double-down on your debt problems by seeking out high-interest payday loans to cover debt payments. “Whatever you do, do not wait until [debt] becomes an emergency,” says Melanie Leigh an Edmonton-based licensed insolvency trustee. The longer you wait, the larger your financial hole will be, and the more limited your available options will be.

How do I get help with a debt problem?

There are some things you can do on your own. “A good first step would be to talk directly to your lenders,” Ms. Singh says. This could be the credit card company or that pesky collector that keeps calling, or a consumer credit bureau, Ms. Leigh says.

There are two in Canada – Equifax and TransUnion – which have websites full of information and resources, and support workers who can help you negotiate with your creditors. “In many cases, securing a lower rate is as simple as contacting the [credit] card issuer and asking for it,” Equifax’s website states. If you can commit to a long-term repayment plan, lenders will likely lower your interest rate to seal the deal. If unforeseen events make payments impossible for a time, ask about a forbearance agreement – a set period of time during which you don’t need to make payments at all.

The next professional to call is a credit counsellor. There are a number of free, not-for-profit organizations that can help you manage your debt. They’ll look at all your financial numbers and “go through a process of elimination” to see what you can cut to free up money to go toward your debt, says Isaiah Chan, vice-president of programs and services at the Credit Counselling Society. Ideally, you just need some guidance to make a budget and commit to a payment plan you can manage. Credit counsellors can help set that up at no charge to you, as they’re paid by creditors who realize that pulling people back from the brink can be better in the long run. (If the non-profit negotiates with creditors directly to create a repayment plan, there can be fees attached.)

If and when you ever near insolvency or bankruptcy, you’ll be referred to another debt professional, an insolvency trustee. Officially licensed by the Superintendent of Bankruptcy, they are “the most highly trained and educated Debt Experts in Canada,” writes BankruptcyCanada.ca. Their fee comes from recovered funds from whatever restructuring plan you commit to, making them free of charge to the client – as required by Canadian law. But let’s not assume the worst; let’s start with the possibility of paying down debt the old-fashioned way.

What is the snowball vs. the avalanche method of debt repayment?

These are two conventional approaches to debt repayment.

First, the snowball: “This method is about low-hanging fruit, where you pay the little debts first to knock them off. Anything less than $500 can be paid off so you don’t have to think about it,” explains Mr. Welker. Popularized by American personal finance writer Dave Ramsey, the snowball method is said to work because of the human psychology of motivation. Watching your debts disappear, one at a time, and getting and bigger every time, is the “snowball” effect that keeps your momentum going.

The avalanche method, meanwhile, is the opposite approach: “You start with the highest interest debt and pay that off first, then work your way down,” Mr. Welker says. More specifically, you’d make minimum payments on all outstanding accounts and then put everything else toward whatever debt is accruing the highest interest rate. That’s very likely to be outstanding credit card debt with interest rates of 20 per cent or more.

Should I consolidate my debt?

Multiple debts can feel overwhelming and unwieldy. Consolidating debt rolls them all into one monthly payment with one interest rate. It means you’ll take on a single “consolidation loan” through a financial institution (a bank or credit union), and your payments are made to them instead of multiple individual creditors.

Besides convenience, says Mr. Chan, another benefit of a consolidation is that a counsellor can often negotiate a lower interest rate than you are paying on the individual loans and debt obligations. You should be careful to do the math, says Chan: “People often rush into consolidation, so before you commit, you need to look at the numbers and know exactly how much you’re saving and if it’s actually benefiting you.”

The catch is that, like every other loan, you’ll have to qualify. You may need security (or collateral) for the loan, and it’s tough to qualify if you have a terrible credit rating. And if you do qualify, there are risks to consolidating. “Sometimes we consolidate a person’s debt, make a plan and figure it all out, but the client doesn’t cancel their card,” says Ms. Leigh. “A year or two down the road, they feel like things aren’t so bad any more and they start shopping again. Soon enough, they’ll have credit card debt and a consolidation loan.”

What is a consumer proposal?

Introduced in the 1990s, consumer proposals are formal, legally-binding agreements between individuals and their creditors to meet somewhere in the middle. “It’s basically a deal we make with someone’s creditors to pay less than they owed,” Mr. Welker says.

To facilitate a consumer proposal, you’ll need a licensed insolvency trustee, though it’s important to remember they don’t work for you, per se. “We’re officers of the court, so we don’t represent either the creditors or the person who owes money,” Mr. Welker says. “We’re more like a referee and we work to arrive at a manageable arrangement for both people.”

As usual, much depends on the size of the debt and its term, but a successful consumer proposal can often reduce someone’s debt by 30 per cent and sometimes much more: If someone is retired, or if they’re sick or injured and can’t work, their debt could be reduced by 80 per cent. Why would your lender suddenly be so uncharacteristically generous? Because they’d rather get something rather than nothing should the individual declare bankruptcy, which is often the individual’s only other option. This is why the consumer proposal has been described as “a gentler alternative” to “its more painful cousin, the personal bankruptcy filing.”

Can I get my debt forgiven in Canada?

Debt forgiveness is a bit of a catch-all term. Any debt that is eliminated, whether a percentage or in its entirety, is said to be “forgiven.” In the consumer proposal above, for example, that lucky retiree had 80 per cent of their debt “forgiven.” Voluntary forgiveness can be through a consumer proposal proper, or occur when a creditor decides the amount owed just isn’t worth the effort to keep trying to collect. Debt Relief Canada, a for-profit group of financial consultants, puts it this way: “If your financial situation is so precarious that you are unable to make even the minimum payments on a credit card debt, the credit card company may decide they would be better off writing off your remaining balance as a loss rather than chasing you for debts you can’t afford,” they write.

What is bankruptcy?

Bankruptcy is basically the opposite of voluntary debt forgiveness. Bankruptcy usually means forgiveness of all debts – including credit card, overdraft and tax debt, plus payday and old student loans – for a fresh financial start.

There are two widely-held (and completely opposite) misconceptions that linger about declaring bankruptcy. “The first is that’s it’s easy to quality for and an easy way out of paying your debts,” Mr. Chan says. That’s not true and neither is the second, he adds, “that it’s the worst thing that can possibly happen to you financially. Bankruptcy is a last resort, but it’s a very realistic option for people dealing with insurmountable debt.”

To declare bankruptcy, you will need to contact a licensed insolvency trustee, who will first walk you through all other possibilities of repaying your debt. “But if that’s just not feasible, if an individual simply cannot afford to make payments,” says Mr. Welker, “then they’ll likely have to file for bankruptcy.”

Filing for bankruptcy doesn’t magically erase all your debts in an instant – it just prevents you from legal action from your creditors while you clean up your finances. If you do so successfully, then and only then will your debts disappear.

What’s the difference between bankruptcy and insolvency?

Though the terms are often used interchangeably, bankruptcy and insolvency are not the same thing. “Insolvency is when you can’t repay your debts; bankruptcy is the formal process or legal proceeding for individuals and businesses to get rid of the debt,” explains Mr. Welker. So if you file for bankruptcy, you are definitely insolvent, but just because you’re insolvent, you’re not automatically filing for bankruptcy.

How does bankruptcy work?

If you decide bankruptcy is the best option, the trustee collects all your personal information and a complete list of your assets and debts to file an application to the Office of the Superintendent of Bankruptcy Canada (OSB). Some of your assets are protected by law and cannot be sold, including pensions and RRSPs as well as necessities like clothes and furniture, but if you’ve got a fancy boat or art collection, they’ll likely be sold by the trustee to help pay the debts owed. If you own a home, the trustee will have it appraised to determine its equity.

Next, your creditors will be notified of your bankruptcy and all legal actions will pause. Your creditors can demand a meeting with your insolvency trustee that you will have to attend, but know that people filing for bankruptcy are sometimes called “judgement-proof” by creditors because creditors have no real recourse to take. Even if your lenders were to take you to court, since they cannot legally cannot garnish your pension, disability payments or most other government supports, they’d be left in the same spot they’re in now. “If there’s no money, there’s no money,” Mr. Welker says.

You’ll also be required to attend two credit-counselling sessions to learn about money and credit management, spending habits, and warning signs of financial difficulties. You may be examined under oath by the OSB, where they’ll ask you about your financial conduct and causes of the bankruptcy.

For the duration of the proceedings, usually nine months for a first bankruptcy and 24 months for a second or more, you’ll have to surrender all your credit cards and submit all paystubs and proof of income. If you fulfill all criteria, you’ll be discharged from the bankruptcy and released from most all financial obligations – alimony or child support payments, court-ordered fines, and new student loans will be excluded.

And will you automatically lose your house? Not necessarily. The trustee will crunch the numbers for you, but if you can make payments on your mortgage you may be able to keep your house. The bank can’t foreclose or repossess your house if the payments are current. However, much depends on how much equity you have in your home (what it is worth minus what you owe on it, including property taxes.) Laws vary by province, but in Ontario, for example, if the equity in your home doesn’t exceed $10,000, you can keep it if you maintain payments. If it’s more than $10,000 and you want to keep it, you will have to pay the equivalent of that equity to your creditors, which might well be impossible. Fortunately, however, this debt too can be consolidated and lowered via consumer proposal.

When you declare bankruptcy, you are assigned the lowest possible credit rating (300) and will have to build it up again, slowly, by making consistent on-time payments. You may not qualify for more credit with this score – which, at least for now, might be a good thing. If you control your spending, manage your finances and pay your bills, the bankruptcy should disappear from your credit history entirely in about seven years.