October 25, 2004

Not all debts are created equally. Some carry higher rates of interest. Others have severe penalties attached for late payments. It pays to know the terms when you borrow, so you know which obligations to pay back first.


Order your debts

By Peter Diekmeyer o Bankrate.com

Although Canadians have been taking on significant levels of household, business and personal debt in recent years, most of us are conservative in nature, and we strive to pay them as quickly as possible. But which ones should we pay off first?

The choice is not always clear. For example credit card debt often carries higher rates of interest than other loans, so one would think they would be first in line. On the other hand, an unpaid traffic ticket could result in your car getting towed. A couple of missed mortgage payments could hurt your credit record for years.

To help you decide which debts to prioritize we've prepared a purely subjective ranking, based on the costs, penalties and other consequences of clearing (or not clearing) up various debt classes.

Government debts

Governments tend to be among the least forgiving creditors. Depending on the level of government, (federal, provincial or municipal), unpaid or late tax bills, tickets or other levies often result in immediate fines or penalties, and are carried at high rates of interest.

For example the federal government's penalty for a tax return that is filed late is 5% of the amount owning, plus 1% for each month that the debt is overdue. These amounts double for second offences. Governments also tend to rank high among preferred creditors in bankruptcies, and will get the best share of your assets, when they are distributed.

As a result, you should almost always clear up government debt as soon as it becomes due. The only exceptions being severe emergencies or financial crises.

Credit cards

In general, credit card debt tends to be among the most expensive around, with interest rates typically running well into the double digits. Although many credit card companies are offering good introductory deals on interest rates, these are often either short-term in nature, or are accompanied by high fees. As a result, paying off your outstanding credit card balances can be one of the simplest and smartest financial moves around.

That said most credit card companies charge no interest at all for the period between when you make a purchase and the statement due date, as long as you pay your balance in full each month. That's a gift that you should definitely take advantage of.

Car Loans

The vast majority of Canadians finance their automobile purchases by either taking on debt or by leasing the car. That said, unless the car is used for business purposes and the interest is tax deductible, car loans are generally a poor deal, compared to alternatives such as increasing your home mortgage.

For example, as of today, a four-year car loan at one of the big five Canadian banks will cost you anywhere between 7% and 8.25%. And you'll do a lot worse at many other financial institutions. On the other hand home mortgages for an equivalent term can be had at about 2 percentage points less. If you have a choice, borrow a little more against your house and pay your car off in cash.

One final note: many car companies offer deals on interest rate financing when they are trying clear out inventory, occasionally even eliminating interest payments altogether. Don't be fooled, these deals are often offered as a replacement for rebates. If you take the low interest rate, you lose the rebate.

Mortgages

Borrowing money on your house is one of the best forms of credit available. It's cheaper than car loans, credit cards and most finance company loans. If you are in financial hot water, or you just want to get ahead of the curve, you're almost always better off maximizing your mortgage and paying off your other outstanding debts.

That said, don't play games with your bank. A household mortgage is a good borrowing option, but don't kill the goose that laid the golden egg. One or more missed mortgage payments can ruin your credit reputation big time.

 

Business debts

For those who are self-employed, or who own their own small businesses, probably the best form of borrowing, and thus the last loans that you want to pay down, are your business debts.

If you borrow money to finance purchases that are used to earn additional income (including a car), the interest on the ensuring loans is tax deductible, and thus the after-tax cost of those loans can be as little as half the cost of non-business loans. In most cases, -- other than the minimum payments required keep your lender happy -- it's better to pay off your personal debt before you start cutting into your business debts.

Family debts

It's ironic that family loans should rank last in the order of debt repayments. But the bottom line is that family members are often far more flexible in extending terms than are most financial institutions. That said, financial conflicts are probably the most prevalent cause of marital and family strife. And there are many observers who would argue that family debts are among the first that should be liquidated when you have the chance.

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Unfortunately there are no hard and fast rules as to how you should order your debts. Each situation will be different. But at a minimum you should take a hard look at the conditions underlying all of the debt that you owe, because not all loans are created equally.

 

Peter Diekmeyer is the Montreal Gazette's management columnist. He can be reached at: peter@peterdiekmeyer.com

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