Thursday, June 11, 2015

Test Your Debt Savvy

As the saying goes, there are more opinions about debt than there are people. Here’s short quiz to test how much you know about debt.


1. A few years ago, newlyweds Emma and Liam decided to buy a house. Their combined income was $100,000 and the bank said they qualified for a $450,000 mortgage. They borrowed $50,000 from their parents as a down payment and were the proud owners of a $500,000 house. The mortgage payments were a stretch, and all the house costs they didn’t know about in advance added to the financial pressure. Even before Liam lost his job, they were starting to run up their credit cards. By the time Liam found new work at lower pay, their high-interest debt was spiraling out of control. They held on for a while, but eventually declared bankruptcy and lost the house. Where did Emma and Liam go wrong?

a) Emma married a loser.
b) Their cheap parents should have given them a larger down payment.
c) They did nothing wrong. Mortgages are good debt and they were just unlucky.
d) Maybe going into debt for a house isn’t always a good idea. People need to have margins of safety in their finances.


2. Sarah just completed her university degree. Unfortunately, she has a $45,000 student debt. It would have been worse without some help from her parents. She could have lived more frugally at school and during the summers, but she just assumed the great job she’d get after graduation would take care of everything. If she had been more careful with her parents’ money and her summer job income, she could have kept her debt down to only $15,000. Once she starts working, Sarah will pay 6% interest per year. If she pays the debt off at $400 per month, how much longer will it take to pay off $45,000 than it would have taken to pay off only $15,000?

a) 6 years and 3 months.
b) Almost no extra time at all if she can get her parents to pay off her student debt.
c) It doesn’t matter. Student debt is good debt. The more the better.
d) About 10 years and 4 months.  Investing in an education is a good idea, but students should still try to keep their student debt to a minimum. The education is good, but the associated debt is still bad.


3. Life is going well for Matt. He has a steady job that covers his rent, food, and other expenses. He’s got some credit card debt, and a car loan. Matt heard that he should have an emergency fund in case he loses his job or can’t work for a while to make sure he can keep covering his loan payments and other expenses. What should Matt do?

a) He should get a line of credit that he can dip into in an emergency.
b) He should just count on his parents to bail him out if necessary.
c) Being in debt is normal. Nervous Nellies should get a life.
d) Owing money on a credit card is a hair-on-fire emergency. He should cut back on spending to pay off the credit card as quickly as possible. Then he should start building an emergency fund and start saving separately for his next car to avoid needing a new car loan.

It shouldn’t be too hard to see which answer I think is right in each case.


11 comments:

  1. The answers are like, "Duhh" but as silly as it seems, I am surprised how many people actually do this stuff. The banks are to blame as well because too many young people are given the impression that, to use the Scotia Bank motto "you are richer than you think" and that is what gets them in debt. There should be more education out there to warn of these schemes. You can't have it all starting out, learn to save!!

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    1. @John: I always translate that ad campaign to "you can borrow more than you think." The c answers are the ones I disagree with strongly, but I've heard from many people.

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    2. Gail Vax-Oxlade says when she sees that commercial she yells at the TV: "No you're not!"

      I enjoyed these Michael, I bet they were fun to write. The answers are pretty clear: the longest answers are your suggestions. :-) Still, some of these might have been harder if they weren't multiple-choice, leaving the reader to answer them.

      What's your take on funding a child's education? Do you think they should pay their own way so they value it more, or should we use RESPs to give our kids a solid "starting from zero" foundation when they graduate university/college?

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    3. @Gene: These were fun to write. Some of my motivation was to illustrate some of the serious problems with the notion of "good debt."

      Perhaps a hybrid approach to funding a child's eduction makes sense. It's unreasonable to expect 18-year olds to earn enough money to pay their whole shot. Making them earn some of it and making their part of the payment visible to them may be the answer.

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    4. Entertaining quiz Michael, I think many people just think "why not, everyone around me do it?" or "the bank told me I can borrow 450,000$ for a house!".

      Even my wife ask me why I make such a priority to max out RRSPs and RESP while making double-down over the mortgage. Most of our friend or relatives do neither of those.

      When going into debt, ask yourself "what if SHTF in my life ?" This is the reason why I would never-ever carry a CC balance or take a car loan. My rule about car is pay cash or pull the LOC and repay on a 4 month schedual. If you can't, the car is just to expensive for you buddy!

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    5. @Le Barbu: It sounds like you and I have similar views on debt. You have to take into account both typical outcomes and bad scenarios.

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    6. @Michael, what you describe here is what I define as "your long term plan looks fine but what if a short term event makes this plan crash?"

      I usually take into account "typical outcomes" to decide if it worth to use debt (samething for investment plan). Then, I look at the bad scenarios to double-check if it still worth, if I can go through it without damages or without panic. If the answer is still YES, then I pull the trigger.

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  2. Great post. Cool format. I read the whole thing carefully to make sure I'd answer wisely.

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    1. @Joey: Glad you liked it. I'm surprised nobody has disagreed with my answers.

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    2. I actually kind of disagree with the phrasing of the last ones "correct" answer. Why save separately ? I've got a combined cash account to be able to take advantage of a market crash, save up for an eventual new car, and is my emergency cash reserve, knowing full well that I can't use the lot up on any single use (other than cash to burn through if everything in life is going badly)

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    3. @Anonymous: You're right that it's possible to combine different types of savings in the same account if you're organized. By "separately" I meant that people shouldn't plan to save for a car out of emergency savings. A different word would have been clearer.

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