Balance Junkie » Debt

How to Solve a Debt Problem

2 Cents — Mon, 06 Dec 2010 10:45:21 +0000

When solving problems, dig at the roots instead of just hacking at the leaves.

~Anthony J. D’Angelo, The College Blue Book

Update: This article was included in the December 13th, 2010 edition of the Carnival of Personal Finance hosted by Mighty Bargain Hunter. Thanks!

There’s little debate that the financial problems we face, both collectively in terms of the economy, and individually in terms of our personal finances, are rooted in debt. We have major balance sheet issues at the public, private and sovereign level. The markets have rebounded significantly, but the real economy has demonstrated a much more muted recovery, and unemployment is still unacceptably high.

Earlier in the year, the debate over economic solutions was focused on the austerity vs. stimulus meme. Austerians wanted severe fiscal cutbacks while Keynesians argued for more stimulus money. The Austerians pointed out that taking on more debt to solve a debt crisis was pure folly, but the Keynesians countered that tightening the purse strings during a severe recession would only serve to choke off the nascent economic recovery.

When the sovereign debt crisis subsequently erupted in Greece, that whole discussion seemed to go by the wayside. Since mounting sovereign debt levels were causing increasingly severe strains on the financial system, the political will to take on more debt for bailouts or stimulus seemed to evaporate very quickly. Taxpayers would not readily agree to shoulder that burden.

Liquidity vs. Solvency

A recent guest post by George Washington on Naked Capitalism reminded us that the BIS (Bank for International Settlements) criticized central banks back in 2008 for easy credit policies, failing to regulate the shadow banking system, and using “gimmicks and palliatives” to try to solve real problems. Around the same time Anna Schwartz, a leading economist with only 92 years’ experience on this earth, warned that the Federal Reserve was trying to fix a solvency crisis by flooding the system with liquidity.

Increased liquidity might temporarily prevent a collapse, but it cannot solve a balance sheet problem. The BIS said that the only real solutions were to:

Let asset prices fall to their fair market value.
Increase savings rates.
Force companies to write off bad debts.

Instead, central bankers and regulators worldwide opened the liquidity spigots, and allowed banks to write up the value of toxic assets by setting aside mark to market rules. The debt burden, however, has not disappeared into thin air. Rather, it has simply shifted from banks to sovereigns to super-sovereigns like the IMF and the Eurozone. What happens when they hit their debt limits? According to Nouriel Roubini, “There’s not going to be anyone coming from Mars or the moon to bail out the IMF or the Eurozone.”

Prosperity = Austerity + Temerity

So with the stimulus option on hold for now, that leaves austerity. But even some of the most fiscally conservative commentators agree that severe austerity measures may only serve to worsen our economic problems. David Rosenberg is not exactly known as a Keynesian, but he recently said that “the dramatic fiscal tightening we are seeing in Ireland and others is insane.” Both he and John Mauldin have pointed to Iceland as an example of how this might be handled better.

In this weekend’s letter, Mauldin quoted from a recent Bank Credit Analyst report which noted that Iceland combined some “draconian” austerity measures with a significant devaluation of their currency. Currency devaluation, however, is not an option for Ireland as a member of the European Union. Rosenberg said “the reason Iceland no longer makes the news is because the krona has been devalued 60%” and it’s already beginning to show a few glimmers of GDP growth. He sees currency devaluation as the way out for highly indebted Euro members as well. The catch is that these nations would have to exit the euro and return to their own currencies to accomplish that objective.

Yves Smith points out that Iceland also “stiffed many of its foreign creditors . . . and its voters turned down an IMF rescue which would have required Iceland to repay foreign creditors of bust Icelandic private banks.” She goes on to assert that ‘Loans are also risk capital, but modern bondholders have rewritten the rules: “Heads I take a risk premium, tails I get taxpayers to eat my losses.”‘ It may not seem fair for debtors to default on their obligations, but that is the risk that creditors sign up for in return for the risk premium they charge.

The bottom line is that the mountain of global debt will have to be restructured, whether that happens through currency devaluations, debt writedowns, or more likely, a combination of the two. But creditors are going to have to assume their share of the pain. Bonds are not risk-free entities and it’s about time bondholders took their lumps along with everyone else. Haircuts are a necessary part of the balance sheet healing process, if only our leaders have the temerity to enforce them.

Pay to Play

My brother-in-law has a saying he likes to repeat the morning after an evening of imbibing: “Pay to play! Pay to play!” The same goes for creditors. Lending money is, or should be, a risky business. There is always a chance the borrower may not pay. Risk enforces discipline on lenders. If you take that risk away, you take away the discipline and bad things happen. (See housing/credit/economic collapse of 2008.)

There is a growing consensus that the solution to our debt problem should be multifaceted, and directed at the root of the problem: balance sheets. We’ve hacked at the leaves long enough with bailouts, quantitative easing, and other liquidity-based solutions. It’s time to take the clippers to the debt and tackle the solvency issue head-on. There are a number of ways to do this:

Modest Austerity Measures: No doubt fiscal restraint has been in rather short supply for a few decades now. While we need to restore some discipline, we need to be careful not to kill the patient in the process. Reasonable spending cuts can help to some extent.
Creditor Haircuts: Some of the debt will simply have to be written down as losses. While governments may shoulder some of that burden, investors and financial institutions need to hit the barber shop too.
Currency Devaluation: I’m not a fan of this one, but many experts seem to believe that debtor nations will inevitably need to lower the value of their currencies in order to decrease the value of their debts.
Smarter Spending: We need to spend money on measures that will actually grow the real economy. I hear so often about aging and decaying infrastructure that it just seems like a no-brainer to funnel some money in that direction. Electricity consumption is quickly outpacing the capacity of the grid. Roads, bridges, and transportation infrastructure all need updating. If we’re going to spend any money, let’s at least use it to solve some problems.

In a capitalist system, we are supposed to pay to play. We’re not supposed to get something for nothing, and the “heads I win, tails you lose” deal speculators and financial institutions have had has got to go.

How do you think we should tackle our debt problem?

(Photo Credit: sashafatcat)

Mixed Messages from TD Bank

2 Cents — Wed, 27 Oct 2010 09:45:21 +0000

The only man who sticks closer to you in adversity than a friend is a creditor.

~Author Unknown

Update: This article was included in the Carnival of Personal Finance #281 posted at Consumerism Commentary. Thanks!

Last week Gail Vaz-Oxlade wrote a really interesting article about The New TD Collateral Mortgage. I was very surprised that I had not heard more about this given that it seems like a pretty big deal to me. As of October 18, 2010, TD will register all new mortgages as collateral mortgages rather than conventional mortgages.

If you’re asking yourself what in the world a collateral mortgage is, you’re not alone. I didn’t know either. Gail goes on to explain it very well in the article. The mortgages most of us have in Canada are conventional mortgages. We have a set amount of principal that we’re borrowing, with a fixed amortization and a term after which we can renew the mortgage. We can easily shop around for a better interest rate from another bank or mortgage company once the term is up.

The Mouse Trap Mortgage

According to Gail, a number of brokers have taken to calling these collateral mortgages “mouse traps.” A collateral mortgage is more like a secured line of credit, like a home equity loan. Here’s what Gail had to say:

“The primary security on a collateral mortgage is a promissory note with a lien on the property for the total amount registered so you can register far more debt against the property than the property is worth. In the case of the TD Bank’s new approach, they are registering 125% of property value, even though that amount may not have been advanced to the borrower initially. (This is a very creative way to get around the government’s new guidelines designed to stop lenders from over-lending to clients on their mortgages.)”

It sounds a bit confusing, but basically, the bank can register the collateral mortgage for an amount that’s greater than the amount they actually lend to you, giving you the ability to easily borrow more if you so choose. It works more like a revolving line of credit. They can also easily change the interest rate on you (by a lot) if you miss a payment. That doesn’t happen with a conventional mortgage.

When it comes time to renew your mortgage, you may be surprised to find out that “most chartered banks will not accept “transfers” of collateral mortgages from other chartered banks, so you have to pay a whack more fees to register a new conventional or collateral mortgage if you decide to move to a new lender.” TD may offer some pretty good teaser rates to get you into these things, but it would be a good idea to look at how the heck you’re going to get out of it if you sign those papers.

Basically, these collateral mortgages will allow those with a tendency to overuse debt to get in way over their heads. Isn’t this exactly the same problem that our neighbours to the south are dealing with right now? U.S. consumers are in a massive deleveraging mode because they borrowed too much money against their homes.

Meanwhile, our Canadian banks are being lauded worldwide as the gold standard in responsible lending and prudent regulation. Now seems like a very peculiar time to allow all of that to unravel. Will the other banks follow TD’s lead and pull that string? If so, you might as well kiss that “Our Banks Rock” sweater goodbye. Cue Undone (The Sweater Song) by Weezer.

New Study by Mouse Trap Manufacturer Finds Surplus of Mice & Cheese

Two days after TD’s new mortgages went into effect, I read an article on Moneyville (a great new personal finance site courtesy of the Toronto Star) that went over a new TD Economics report. Guess what that report said? It seems that “Canadian debt loads have become excessive as consumers get more accustomed to easy borrowing.” The Moneyville headline put it this way: Many Households on the Brink, TD Bank Says.

I can see it all now . . . I’m your banker and I’m here to help. Too much debt you say? How about a loan? . . . Am I the only one who finds this farcical? These are exactly the same practices that trashed the U.S. and global economy. It’s like your neighbour just burned down his house by fooling around with his gas lines and you suddenly decide now’s the time for a do-it-yourself furnace installation.

If you have a mortgage, do yourself a favour and go read Gail’s article. Forewarned is forearmed. Next, head on over to Moneyville. TD’s got some great info for you on how “debt will continue to rise more rapidly than income.”

Read that last sentence again. Then start looking at how much debt is lurking on the liability side of your balance sheet. Do a little math to figure out the real cost of that debt, get your own personal debt clock ticking, and start making a plan to do whatever it takes to get rid of it. That way, when the bank munificently offers to help you out, you can tell them that you’re not interested in their cheese or the potentially fatal snap that comes with it.

What do you think of these collateral mortgages, especially in an environment where debt is an increasing problem?

Debt Clock: What Does Yours Look Like?

2 Cents — Thu, 13 May 2010 09:45:08 +0000

Who recalls when folks got along without something if it cost too much?

~ Kin Hubbard

Update: This article is included in the Carnival of Personal Finance #257 – Canadian Bank Notes Edition posted at Canadian Finance Blog. Thanks!

The sovereign debt crisis has been front and centre lately in light of the recent market earthquakes emanating from the European Union. Sunday’s EU bailout seems to have settled markets for now. But the problems have not gone away and if you look at the U.S. Debt Clock , the U.K. Debt Clock, or even the Canadian Debt Clock, you’ll notice that they are all still ticking higher by the second. There is even a debt clock that contends that the true U.S. debt is more than 6 times the reported number if you factor in unfunded liabilities.

Yesterday Big Cajun Man at Canadian Personal Finance Blog wrote Of Debts and Deficits. In the comments section, he proposed a new country with a no debt clause in the constitution and I offered to take the citizenship oath. Who’s with me?

U.S. National Debt Clock

Your Personal Debt Clock

The spotlight shining on the high debt levels of many countries across the globe may have temporarily blinded us to another debt hot spot – one that we can actually do something about. I’m talking about personal debt. Do you know exactly how much debt you’re carrying? Do you know how much it’s growing (or shrinking) each month? The CGA (Certified General Accountants) released a study that has gotten a lot of play in the media. There have been a number of articles out lately that have literally brought home the fact that the growing personal debt problem is every bit as important as the sovereign debt issue:

Tavia Grant reports in the Globe and Mail that Canadian household debt has soared during the course of the recession. Far from taking advantage of low interest rates to pay down debt, we have instead elected to take on more. In fact, with our debt to financial assets ratio hitting 144% at the end of last year, we are first in that category for 20 OECD countries. Oh Canada! Didn’t we used to rank near the top in terms of wise fiscal stewardship? What happened? The study quoted here says a lot of it has to do with the “culture of consumption”. Perhaps we are close to finding out exactly how ugly the ugly part of low low interest rates might get.
Chaya Cooperberg’s Home Cents blog announced that Financial Reality Bites for Generation X. As a Gen Xer myself, this one hit close to home. The portraits of people in their late 30s and early 40s with kids, a huge mortgage, credit card debt, and little to no retirement savings looked very familiar.
Canadian Mortgage Trends also cited the CGA study, holding it up as The Latest Reality Check on Debt. They point out that a 2% mortgage rate hike would mean a 9% to 11% spending reduction for most middle to upper-middle income families. Given that a large number of us are currently living pay cheque to pay cheque, that puts our economy in a precarious position should a rise in any of the following occur: 1) unemployment, 2) interest rates, 3) taxes. (Incidentally, Kevin Press of Today’s Economy posted Another Look at Mortgage Rates, in which a mortgage pro questions the now-conventional wisdom that mortgage rates will rise a lot fairly soon. This analyst doesn’t think so, and I agree with him. More on that in a future post.)
Angela Self’s Smart Cookies blog asked You’re Saving for What? This article also referenced the CGA study, pointing out that many of us are heaping up debt to pay for essentials rather than extras. That can’t be good for our economy for very long. There are some great ideas here on how to cut spending and redirect your income to areas that will help you reduce your debt. Check it out!

How to Defuse a Debt Time Bomb

If you want to set up a debt clock for yourself, you might want to look at The Cost of Debt: Doing the Math. There are some useful calculators and examples highlighted there that you might find helpful as you face your own debt reality. Go ahead. Look. How bad could it be?

OK, so maybe it doesn’t look great. The good news is that, by actually acknowledging your potential debt time bomb, you have taken the first step to defusing it. Here are a few “next steps” to consider:

1. Change Your Attitude: In order to get to work on defusing your debt bomb, you really have to want it. What are you willing to give up in order to enjoy debt freedom?

2. Cut Spending: Depending on how close you are to detonation, you may want to consider your own set of austerity measures. (Sit down and negotiate with all family members first in order to avoid riots. )

3. Reallocate Resources: Once you have cut spending, you need to make sure the money you’re saving is going where it’s needed most. Whether you choose a snowball, snowflake, or avalanche approach, attack your debt relentlessly until it reaches zero.

How About a Savings Clock?

Does that sound strange? Can you imagine a clock that’s running up ever-higher numbers that are actually tracking mounting savings? That’s what can happen when we eliminate debt and get our heads above water. The power of compounding can work for us rather than against us.

With storm clouds continuing to gather on both the national and personal debt horizons, it’s tempting to ask how this all happened. Why can’t we get it together either at the national or personal level? I’m not sure. But I think it has something to do with the fact that we’re all suffering from a kind of inertia. We’ve been doing this for a long time now, and nothing really bad has happened yet – at least nothing that couldn’t be fixed with another round of debt for all. Escalating debt seems normal.

The “reality check” theme was really prominent in a lot of the articles I highlighted here today. But I don’t think anyone administers a dose of reality better than Gail Vaz-Oxlade. If anyone can shake us out of our collective “it will all turn out OK somehow” stupor, it’s Gail. She recently summed it up like so: Debt Isn’t NORMAL. Take a moment to read the article and then start winding back your debt clock so that you can start up your savings clock – and hey, maybe your government will follow your example!

Have you looked at your debt clock lately? Is it counting down or rolling forward?

Financial Spilled Milk: Macbeth Meets Ponzi

2 Cents — Tue, 11 May 2010 09:45:41 +0000

It doesn’t matter how much milk you spill, just so long as you don’t lose the cow.

~ Mark Guilbeau

“Fair is foul and foul is fair.” (Macbeth, Witches, Act I, scene i) The EU is the latest hero in the bailout bonanza. A paltry trillion dollars bought a rip-roaring short-covering rally on stock markets world wide yesterday. So why don’t I feel all better?

Once again, we are perpetuating a cycle that’s running in reverse. In a capitalist system, we’re supposed to reward success and let the failures fail. To use the forest fire analogy that I’ve used before in my discussion of the CMHC and Fannie Mae, we’re still holding up the dead wood and choking out new, healthy growth. If we continue to reward failure, failure is what we’ll continue to get.

Welcome to the Money Pit

“Welcome back my friends to the show that never ends. We’re so glad you could attend. Come inside, come inside!” ~ Emerson, Lake & Palmer (I have been unable to get this song out of my head since Sunday evening.)

Against their own rules, the EU has now joined the dubious cabal of nations printing money to buy their own bonds and keep borrowing costs for profligate sovereigns down. Fannie Mae and Freddie Mac in the States are going to need more money – lots of it. The current version of the U.S. financial regulatory reform bill does nothing to address Fannie, Freddie, or the multi-billion dollar money pit that they represent.

Swap lines have been re-opened by global central banks (including the Bank of Canada) to ensure liquidity in the currency markets. That’s great, but it’s a sign that the system is in crisis – again. Even with the gargantuan EU bailout, Greece will still be in worse shape 3 years from now. You cannot solve a debt crisis with more debt.

The Spilled Milk Cycle: Capitalism in Reverse

With the ever-narrowing time lag between financial crises and the shrinking number of solvent entities whose pockets we can pick for spare bailout change, it feels like this cycle of capitalism in reverse has got to come to a climax sooner rather than later. Here’s a simplified recap of the Spilled Milk Cycle:

1. Debt Levels Climb: Consumers, businesses, and/or countries take on more debt while a small group of doubters warns that this will not end well. These folks are ignored.

2. A heavily indebted company or country gets into serious trouble and can’t make a payment on their debt.

3. The public is both angry and worried: They are angry about using public (taxpayer) funds to bail out people who acted irresponsibly, but worried that allowing the failures to fail will bring down the whole system.

4. There’s no sense crying over spilled milk: Since we are on the brink of a systemic failure, there is no time to point fingers, assess blame, or figure out what caused the crisis. We are all victims of the crisis. Instead of addressing the root cause, we use whatever means necessary to mop up or cover up the problem. Trillions in new debt are issued and those responsible are heroes!

5. Hearings & Investigations Leading Nowhere: We make a half-hearted attempt to figure out what caused the crisis by holding endless hearings. Each hearing is but “a poor player that struts and frets his hour upon the stage and then is heard no more. It is a tale told by an idiot, full of sound and fury, signifying nothing.” (Macbeth, Act V, scene v)

6. Business as usual: Keep the debt rolling. More bonds (debt) are issued. Older bonds are rolled over into newer ones. Next, it’s back to Step 1 and the milk spills again! Now who could have predicted that?!

Bienvenue Chez Ponzi!

Welcome to the house of Ponzi! It’s very spacious, and built on a large lot with lots of room for expansion. It’s constructed entirely of playing cards, and it can be yours today for a low, low price, $0 down, and 0% financing!

In an earlier article, I mentioned Hyman Minsky’s Financial Instability Hypothesis. As part of the debt accumulation aspect, he identified 3 types of borrowers:

1. Hedge Borrowers: can make principal and interest payments from current cash flows.

2. Speculative Borrowers: cash flows cover the interest due, but the principal must be continually rolled over or refinanced.

3. Ponzi Borrowers: cannot make principal or interest payments. The only way for them to stay solvent is to rely on the appreciation of the underlying asset. (Sound familiar?)

Many borrowers across the globe, whether they are consumers or countries, have at least become speculative borrowers. A growing number are headed for the house of Ponzi. The U.S., the U.K., and the P.I.I.G.S. (Portugal, Italy, Ireland, Greece, and Spain) must also be included in the latter category. It could easily be argued that Greece is already there and it’s not a stretch to contend that the global economy as a whole is starting to resemble a giant Ponzi scheme.

Unfunded liabilities mount daily. Successive financial crises are “solved” by issuing debt on top of debt. This is no more sustainable than your classic Ponzi scheme and it’s only a matter of time before the house of cards collapses.

Somebody Please Pick Up That Milk Can

So here we are with another can of spilled milk in front of us. Will we continue the cycle by rewarding failure? Will we kick the can down the road yet again, hoping that our children will somehow figure out a way to clean up the mess we’ve left for them?

It looks like that’s the path chosen by our fearless leaders. We’re in danger of losing the cow. We need to finally cry over this spilled milk if we’re to truly fix the problem. Please – No more hearings. No more bailouts. No more dead wood. Don’t kick the can. Pick it up and figure out a way to keep from spilling it again.

The markets are celebrating. Hooray for spilled milk! We’re at Step 4. I’m waiting for the sound and fury of Step 5, but under my breath I’m mumbling “Out, damned spot! out, I say!” (Lady Macbeth, Act V, scene i).

Update: I just finished writing this and found these articles that seem to echo my sentiments (without Macbeth & Ponzi). The difference is that Danielle Park and John Hussman know way more about this stuff than I.

Why Are Mortgage Rates Rising?

2 Cents — Fri, 02 Apr 2010 09:45:05 +0000

People are living longer than ever before, a phenomenon undoubtedly made necessary by the 30-year mortgage.

~ Doug Larson

Update: This article was included in the Carnival of Financial Planning #136 posted at Bargaineering. Thanks!

On Monday, several Canadian banks boosted their fixed mortgage rates by 60 basis points (.60%). That’s a pretty big hike all at once. The Globe and Mail ran the following headline: Mortgage Rate Boost Signals Rock Bottom Era Is Over. Can’t you just hear all those folks who just signed up for variable rate mortgages scurrying to lock in fixed rates?

We had to renew our mortgage a while ago when rates were higher and currently have a 5-year 5.49% rate. Unfortunately, (or fortunately?) it’s not as easy to renegotiate mortgages in Canada as it is in the U.S., so we have tried to do the only thing we could: pay it off faster. That 5.49% rate is higher than a GIC and safer than the stock market.

How Are Mortgage Rates Set?

Mortgage rates are determined by a number of factors. Those factors can be different, depending on whether you’re talking about a fixed rate or variable rate mortgage. Let’s take them one at a time:

Fixed Rate Mortgages: These rates are generally determined by the bond market. If the yield on a 5-year government bond has recently risen, chances are you will see a similar hike in 5-year fixed mortgage rates.

Variable Rate Mortgages: These rates are determined by the Bank of Canada target for the overnight rate. That’s the announcement we get every month or two at 9 A.M.. You’ll generally see it reported in the business news, unless something unusual is happening (as has been the case over the past couple of years). In that case, it might make the headlines in the mainstream media.

In general, central banks have greater control over short term rates, whereas bond traders have more control over longer term rates. You can read more about the mechanics of the bond market in Where Are Interest Rates Going?

What Caused Monday’s Mortgage Rate Increase?

According to the Globe article cited at the top of this post, 5-year Canadian government bonds have risen .25% since February, caused by improving economic data and nascent inflation fears. But why has a 25 basis point boost to government yields translated into a 60 basis point hike in mortgage rates?

I’m no expert on these things, so I would love to have some input from those who know better than I. Nevertheless, I have a theory. There were a couple of U.S. bond auctions last week that didn’t go as well as expected. That means that bond buyers demanded higher than expected rates as compensation for their investments.

The unsightly fiscal situation south of the border is well-documented, but they have been able to finance their burgeoning debt quite easily up to this point. It could be that the market is beginning to experience the indigestion that I’ve written about in the past, or it could be that China is sending the U.S. a subtle warning.

Last week, there were protectionist rumblings by some U.S. politicians who think that the U.S. should exert more pressure on China to revalue the yuan (the Chinese currency). Scholars of the Great Depression know that protectionism was one factor that deepened and prolonged the economic turmoil of the 1930′s. Read John Mauldin’s latest letter for some thoughts on this as well as an answer to the question What Does Greece Mean to You? At any rate, I doubt that China appreciated this protectionist pressure and they may have been tepid in their bond auction participation as a result.

What Are the Implications of Higher Mortgage Rates?

According to Benjamin Tal, as quoted in the Globe article: “while interest rates are at historical lows, affordability, or consumers’ ability to cope with their debt is not.” Interest rates have been low for a very long time and that has lead many consumers to take on more debt, both in terms of mortgages and consumer debt.

Many Canadians are already maxed out in terms of spending and debt. If rates were to rise, that could just be the tipping point for a renewed economic crisis. High unemployment and underemployment levels only exacerbate the situation.

The Globe ran another article on Tuesday that cited a new Conference Board of Canada study that said Many Struggle to Afford Their Homes. According to the study, about 20% of Canadians are having a hard time keeping up with the cost of their homes. Housing costs were considered unaffordable if they exceeded 30% of pretax income.

Can’t the Central Banks Just Lower Rates Again?

Well, not really. If they were to raise rates at some point and then choose to lower them again, that would be a possibility. But at the moment, short term rates just can’t go much lower. Complicating matters further is the fact that, as mentioned above, central banks don’t have much control over the longer term rates that determine fixed rate mortgages. Let’s hope the bond vigilantes don’t decide to kick up a fuss anytime soon.

Many pundits have contended that a massive wave of inflation will eventually head our way as a result of loose monetary policy and lots of money printing. While I think they are on the right track, I don’t think that inflation will be the reason rates rise in the near term. In fact, I think we may be in for some debt deflation first.

Again, I’m no expert on this. I’m just thinking out loud. I’m wondering if it’s possible that we could see a deflationary environment coupled with rising rates at the long end of the yield curve. In this scenario, rates would rise due to a lack of appetite for bonds rather than as a result of inflation.

Once I start thinking in these terms, I get dizzy pretty fast. I would love to hear some ideas on this, as I’m not sure if it’s even possible, or if there’s any precedent for such a scenario. Normally, deflation is associated with lower rates if I’m not mistaken. Would renewed economic trouble lead rates lower, or will bond traders take them higher based on global fiscal problems?

Can anyone shed some light on this for me? Is it possible to have rising rates during a deflationary period?

Are you prepared for an increase in interest rates? How will it affect your household?

How to Effectively Use Cash Back Credit Cards and Maximize Rewards

2 Cents — Thu, 25 Mar 2010 09:45:27 +0000

The following is a guest post by Kevin Fleming. Kevin runs CreditShout, a personal finance blog dedicated to educating people on how to manage their finances and reviewing cash back credit cards.

__________

First I would like to start off by saying that credit cards are only worth using if they are used responsibly. The methods I describe below will only work if you pay off your balance in full each month. Never carry a balance. You will end up paying more in interest than you will ever earn in rewards. If you pay off your balance in full each month, you pay nothing in interest which allows you to really reap the rewards that some of these cards offer.

With that said, there are three keys to effectively using your cash back cards. The first involves choosing a cash back card that rewards your specific buying behaviors. The second involves maximizing your cash back by using your credit card as much as possible. The third, as I mentioned above, involves minimizing fees and costs by avoiding carrying a balance or incurring other charges.

Choosing a Cash Back Card

You’ll want to make sure to choose a cash back card that rewards you for the purchases you are already making. For example, some cards provide additional rewards or incentives for buying plane tickets, gas or groceries. Others reward restaurant purchases or movie-ticket buys.

When researching cash back cards (also called money back credit cards), make sure you choose one that makes sense for you. If you live in a large city and take public transportation everywhere, for example, a card that gives a bonus 5 percent cash back on gas would not be a wise decision for you, but perhaps a card that offers cash back for restaurant buys would if you eat out a lot.

If you have multiple categories where you tend to spend more, you can consider a card such as the Discover More Card, which rotates through five popular categories, offering you cash back bonuses in each at different times throughout the year.

Do the research to find the perfect card for you in order to maximize your cash back benefits.

A word of warning, when looking into credit cards in general – You almost always want to avoid retail store cards. Cards such as the Best Buy credit card or Victoria’s Secret credit card may seem like they offer a lot back, but you can only earn a decent amount of rewards points on in store purchases. With a cash back credit card like Discover More – you earn cash back on almost every purchase you make regardless of the store.

Using Your Card

Use your cash back card as much as possible in order to reap the best rewards benefits. See if you can make rent or utility payments using your card. Most cell phone companies will allow you to pay your bill via credit card as well. Any time you are going to spend money anyway, put it on the card. You can even offer to pick up the entire tab for dinner and collect the cash, or see if your boss will let you put your travel and work related expenses on your cash back card and then reimburse you.

Avoiding Fees

Cash back benefits are negated if you have to pay interest on your card. Pay your balance in full each and every month in order to avoid paying interest fees. You can set aside the money every time you charge something to make sure you can pay off the card in full, or even make multiple monthly payments online throughout the course of the month, paying off the amount you charged every time you use the card so no balance ever builds up.

You’ll also want to make sure to avoid late fees and other penalties, such as over-the-limit charges. Set up automatic bill pay to make sure your payment is sent in before the due date and monitor your credit card limit so you don’t get close to going over.

If the card has an annual fee, make sure you evaluate the rewards program to ensure it is worth it to the pay the fee. Since many cash back cards don’t charge a fee, only accept one that does if the extra benefits you will earn on that particular card completely cover the cost of the charge.

Do you use a credit card that offers rewards? What are your favourites?

The Cost of Debt: Doing the Math

2 Cents — Tue, 23 Feb 2010 10:45:15 +0000

No man’s credit is as good as his money.

~ E.W. Howe

Update: This post is included in the March 1st, 2010 Carnival of Debt Reduction. Thank you!

When we take on debt, we’re essentially borrowing from our future earnings in order to have the things we want right now. There’s a cost for that. It’s called interest and it can exact quite a toll on the balance sheet. I’m always writing about how you need to do the math in order to make good financial decisions, so I thought I would give a few examples here of how much various types of debt can cost over time.

In general, there are 3 main types of personal debt that we tend to incur: mortgage, vehicle, and credit card loans. Each carries with it a unique cost structure that’s worth looking at. The chart below provides some sample calculations for each of the three kinds of personal debt. I tried to change only one factor at a time so that you could easily draw some comparisons.

The car loan section was difficult, as financing rates can vary widely from 0% to 5% or even higher depending on where you’re getting the financing. I chose 1% and 3% almost arbitrarily after looking at a couple of websites. The cost of financing a car isn’t all that onerous at those rates, but if rates rise, the picture changes a lot.

To do the mortgage and the car loan calculations I used the Canadian calculators at dinkytown.com. For the credit card calculations, I used the excellent calculator provided by the FCAC on their website. In addition to the links in this post, you can always find these calculators in the “Resources” links on the right side of the page.

The Cost of Debt

Those credit card figures are not typos. Making minimum payments only is extremely expensive. If you play around with the FCAC calculator, you’ll notice that paying even a small amount above your minimum can make a huge difference in the time it takes to pay off your balance and in the amount of interest that you’ll pay.

For example, if you have $5000 in credit card debt and you pay an extra $10 a month above your minimum, you’ll save $6550 in interest and shave 25 years and 1 month off your payment time. If you make fixed payments of $150 a month instead of the minimum, you can save $12 165 in interest and pay off your balance 40 years and 2 months sooner.

Of course, the ideal way to handle it would be to pay off your balance in full each month, thereby incurring zero interest charges. That way, you will put yourself in a position to save money for your future rather than taking it away from your future earnings. One take-away from this chart is that if you must take on debt, try to borrow from any source other than a credit card company. Most banks will offer lines of credit that are much cheaper.

If your eyes didn’t glaze over at the sight of so many numbers, did you find anything interesting or surprising here?

The Lexicon of Debt: Is Debt Evil?

2 Cents — Mon, 22 Feb 2010 10:45:18 +0000

He looks the whole world in the face for he owes not any man.

~ Henry Wadsworth Longfellow

I’ve been writing a lot about sovereign debt and the dangers it poses to the global economy lately. Debt in general is a frequent topic in the personal finance blogosphere and it is often painted as the enemy – a nefarious villain, evil incarnate.

I happen to agree with the contingent that says that there is no such thing as good debt. That doesn’t mean you can’t ever have debt. It just means that you need to control it so that it can’t control you.

Debt, by its very definition, is negative. It means below par, under water, less than zero. On your balance sheet, it’s a liability. Liability is defined as “the state of being legally obliged and responsible” or “anything that is a hindrance or puts an individual or group at a disadvantage”. So it looks like debt is not good. But is it inherently evil?

Debt, like money, is not evil in and of itself. But it has truly become a four letter word – and for good reason. It’s been used and abused. The rules of the debt game have changed and not everyone got the memo. In the U.S., banks have been allowed to hold less cash to back up loans and have given those loans to anyone who could fog a mirror.

When they inevitably went bad because the debtors could not pay, the debtors lost their homes and went bankrupt. The bankers got a taxpayer-funded bailout. Yeah. That means that you and I are footing the bill for the idiotic mistakes of both lenders and borrowers. (If you think my characterization is too harsh, read what Matt Taibbi had to say about Hank Paulson.)

The Lexicon of Debt

So is it the debt that’s evil, or are people using it unethically? Well, let’s ask the thesaurus. Here’s a rundown of the various words associated with “debt”:

Nouns: obligation, liability, charge, default, bankruptcy, insolvency, usury, deficit, insufficiency, poverty, encumbrance, hypothecation, failure

Verbs: owe, borrow, run a tab, finance, repudiate, dishonour, write off, borrow from Peter to pay Paul, outrun the constable (I’ve never heard of that last one before.)

Adjectives: indebted, liable, chargeable, answerable for, in embarrassed circumstances, in difficulties, up against it, in the red, in the hole, in hock, broke, in arrears, delinquent

It seems to me that two main themes arise from this terminology:

Debt Is Negative: Terms like insufficiency, bankruptcy, default, dishonour, in embarrassed circumstances, delinquent, and ultimately, failure, do not conjure up feelings of pride and accomplishment. The message is that debt is to be used wisely, if not avoided altogether.
Debt Means Responsibility: If you take on debt, you are legally obligated to pay it back, or the consequences are severe. You can lose precious assets, or even your freedom – unless you are a “systemically important” financial institution. In that case, anything goes and the taxpayer’s got your back. Can you say moral hazard?

The implications of debt provided by the thesaurus tell us that debt, while not a desirable condition, is not evil. I think the responsibility factor is the locus of our problem. Neither institutions nor individuals seem willing to accept the responsibilities inherent in a debt contract.

Under a properly functioning capitalist system, the borrower is supposed to incur no more debt than he or she can realistically pay back or he or she will lose the posted collateral. (That’s right, you used to need to have some skin in the game.) The lender is not supposed to lend more than the borrower can realistically pay back, or he or she will lose the money lent. (Unless the government decides to replace that money with taxpayers’ cash.)

So maybe debt is not a villain after all. It’s more like the super power that a villain might possess. There’s nothing wrong with the power. It’s just being used by a villain. What if we gave it to a hero instead? Wanted: heroes.

(Update: This post was included in the Money Hacks Carnival #106 hosted at Living Richly on a Budget. Thanks!)

What do you think? Is debt evil or just abused?

6 Remedies For a Debt Hangover

2 Cents — Mon, 04 Jan 2010 10:45:20 +0000

Cheers to a New Year and another chance for us to get it right.

~ Oprah Winfrey

OK, so you overindulged. You read all of those articles warning about moderation or complete avoidance. You intended to follow that prudent advice. But you didn’t. I could easily be talking about alcohol consumption or debt consumption. Either way, over-consumption will put you in a precarious position.

If you’re not in that position on either front, congratulations. If you are, you’re not alone. Debt has been in the news a lot lately and if you read my post on 2010 What Ifs, you know that I think it will be a big topic this year. Sovereign debt problems are simmering in many parts of the globe and are coming to a full boil in others, particularly the PIIGS countries. This has led many to ask the question: Is sovereign debt the new subprime?

Bank of Canada Governor Mark Carney has been pushing debt prudence, and Rob Carrick wrote an article warning us to wrestle down our debts. (If you want a deeper understanding of the economic effects of debt and the consequent deleveraging that it necessitates, you can read John Mauldin’s recent newsletter on the topic.)

Feeling guilty about your over-consumption won’t help and there’s no sense crying over spilled egg nog. So how do we cure a hangover? I thought we’d first look at a few of the remedies for an alcohol hangover and then see if we could draw any parallel cures for a debt hangover.

6 Hangover Remedies

Sleep: Get some rest and let your body heal and recover. How long you need to sleep will depend on the severity of your hangover.
Replenish Liquids: Excessive alcohol leads to dehydration. Rehydrating with water, juice, or sports drinks like Gatorade helps counteract that.
Avoid Caffeine: Some home remedies call for black coffee. Medical experts tell us this just makes things worse, as it contributes to further dehydration.
Physical Activity: I guess the severity of your hangover might dictate how vigourous you want to get with this one.
Eat Healthy Foods: Many recommend foods high in minerals like pickles (?) and fish.
Hair of the Dog: I never understood how consuming more alcohol could possibly help, but I know some people swear by this “remedy”.

6 Debt Hangover Remedies

Stop/Control Spending: It’s the old “if you’re in a hole, stop digging” thing again. How strictly you limit your spending should be directly tied to the severity of your debt problem. If you have only incurred modest debts, cut your spending accordingly. If, however, you are in so much debt that you can barely make your minimum payments, you will need to make cuts that are painful, but absolutely necessary. Just think how great you’re going to feel when that debt hangover is gone.
Replenish Cash: Once you have cut spending and paid down your debt, you need to build savings. If you can keep your spending cuts in place, use the extra cash to build an emergency fund so that unexpected or sudden expenses won’t lead to another debt hangover.
Avoid Malls and Credit Cards: Avoid places that normally cause your spending discipline to falter. If you are someone who overuses credit cards, don’t bring them with you when you go out unless you have a specific purchase in mind. Buy only the items you planned on and do not pay more than you have budgeted for those items. Otherwise, your debt hangover will only get worse.
Physical Activity: This can be good for a debt hangover as well. It can reduce stress levels, increase your overall health, keep you out of the mall, and help you work off those holiday calories.
Consume Wisely: Counteract poor spending practices by resolving to organize your finances, assess your balance sheet, set a budget, and save for your future. You can read more about these topics in the Balance Basics series. Adopt healthier consumption habits like cutting down eating out, shopping only with a list, and planning larger purchases in advance. (By the way, alcohol can get pretty expensive too, so if you cut that down or out, you can kill 2 hangovers at once!)
Hair of the Dog: Again, I don’t get it. I can’t see any conceivable way this could help with a debt hangover. Well, maybe if you swapped some high interest credit card debt for lower interest debt on a line of credit? Still, that’s just moving debt around.

If you think you might need professional debt advice to sort out your money problems, try this site.

So what do the medical experts say about hangover “cures”? According to the British Medical Journal:

The alcohol hangover has substantial economic and health consequences.
Compliance with moderation to prevent alcohol hangover is poor.
No compelling evidence exists to suggest that any conventional intervention is effective for treating or preventing the alcohol hangover.
The most effective way to avoid the symptoms of alcohol-induced hangover is to practice abstinence or moderation.

You could easily replace “alcohol hangover” with “debt hangover” in every point above and you’d have it just about right.

Are you suffering from a debt hangover after the holidays? What is your plan to cure it?