On July 11th, the Bank of Canada raised the interest rate by a quarter of a per cent. I use an example case study to outline how the tips for paying off your debt in my previous video “Strategies to Pay Off Debt” can affect your debt repayment. The basic guidelines I outlined in that post are:
Gary is a recent university graduate. He received some funds from OSAP to complete his chemistry degree which didn’t cover all his fees so he had to take out a line of credit too. When he graduated, he used some of his Line of Credit limit to furnish his apartment. At the same time, he also took out a car loan to buy a used car for his commute. Gary receives a salary of $50,000, with bi-weekly paycheques.
Gary’s OSAP loan is for $7,500 and is a variable loan of Prime + 2.05% with a minimum payment of $85.50 per month. The amount of Gary’s car loan is $12,500 with a rate of Prime + 1.95% and minimum monthly payments of $205.10. Finally, his Line of Credit has a balance of $15,000 at an interest rate of Prime + 4.5%. The minimum monthly payment is 1% of the loan balance or $50, whichever is greater. With a balance of $15,000 his first minimum payment is $150. In total, Gary has $35,000 in debt. Prime is currently 3.7%.
| Loan | Balance | Interest Rate | ||
|---|---|---|---|---|
| Quoted Rate | Current Total | |||
| OSAP | $7,500 | Prime + 2.05% | 5.75% | |
| Car Loan | $12,500 | Prime + 1.95% | 5.65% | |
| Line of Credit | $15,000 | Prime + 4.50% | 8.20% | |
Paying only the minimum payments, Gary will incur the following amounts on his loans:
| Debt Repayment Strategy | Total Debt Payment | Total Interest Paid | Time to Repay Loan |
|---|---|---|---|
| Minimum Balances Paid | $64,590.19 | $29,596.19 | 516 Months |
As you can see, it’s important for Gary to pay off those loans as quickly as possible.
The first step is to apply the debt avalanche method. In other words, paying off loans with the highest interest rate first. Right now, the line of credit has the highest interest rate at 8.20%. The next highest is the OSAP loan with an interest rate of 5.75% and behind that, the car loan at 5.65%.
| Order of Debt Repayment | Balance | Interest Rate |
|---|---|---|
| Line of Credit | $15,000 | 8.20% |
| OSAP | $7,500 | 5.75% |
| Car Loan | $12,500 | 5.65% |
However, you can claim a credit on your tax return for the interest you paid on the government student loan whereas bank student loans don’t receive this tax credit. In Ontario, Gary gets a 20.05% tax credit on his OSAP interest and reduces his effective interest rate to 4.60%. This means the order changes to:
| Balance | Interest Rate (after-tax) | |
|---|---|---|
| Line of Credit | $15,000 | 8.20% |
| Car Loan | $12,500 | 5.65% |
| OSAP | $7,500 | 4.60% |
OSAP loans are also eligible for Repayment Assistance if you become disabled or simply don’t earn enough to pay back the minimum payments. If the rate on your OSAP loan is higher, it may still make sense to pay off other loans first since the government has these repayment options if you run into financial trouble.
Now that Gary is putting 20% of his after-tax income towards debt repayment based on the budgeting guidelines in my “How Much Should I Spend Each Month?” video, $700 per month is going towards his debts. Gary will pay the minimums each month, and put an extra $259.40 towards the Line of Credit until it’s fully paid off.
| Order of Debt Repayment | Balance | Interest Rate |
|---|---|---|
| OSAP | $7,500 | 4.60% |
| Car Loan | $12,500 | 5.65% |
| Line of Credit | $15,000 | 8.20% |
If Gary used the debt snowball method instead and paid off the OSAP first and the Line of Credit last, he’d pay an extra $836.52 in interest, lose out on $235.04 in tax credits, and delay his debt repayment by a month.
| Total Debt Payment | Total Interest Paid | Time to Repay Loan | |
|---|---|---|---|
| Debt Avalanche | $40,924.53 | $5,924.53 | 59 Months |
| Debt Snowball | $41,761.05 | $6,761.05 | 60 months |
| Difference | $836.52 + 235.04 tax credits | 1 month |
The second guideline is to pay off the debts as soon as you have money available. For this comparison, I assumed that Gary is still paying off an equivalent of $700 per month towards the loans. In the first scenario, Gary puts the minimum payment toward the loan each month automatically but only puts the additional amount towards the loan at the end of three months, when he has a $778.20 lump sum. This results in total interest of $6,119.15 paid and the loan paid off over 60 months. The second scenario takes Gary’s $700 per month budget for paying off the debts and splits it into bi-weekly amounts of $323.08. Making bi-weekly payments rather than extra lump sum payments every 3 months saves $381.08 in interest by the time the loans are paid off and knocks a month off the time to repay the loan. Simply setting a different payment frequency allows Gary to save interest costs without changing the total amount put towards the loans each month.
| Total Debt Payment | Total Interest Paid | Time to Repay Loan | |
|---|---|---|---|
| Lump Sum Payment at end of 3 months | $41,119.15 | $6,119.15 | 60 Months |
| Bi-weekly Payments | $40,738.07 | $5,738.07 | 59 months |
| Difference | $381.08 | 1 month |
The final guideline around debt repayment is to pay off as much as possible, as quickly as possible. After sitting down with Gary and reviewing his budget, we determine that he would be able to put $1,000 per month towards his debt by cutting back on some of his discretionary spending. Since he’s getting paid bi-weekly, Gary sets up an automatic $461.54 towards his debt every 2 weeks. Putting 30% of his after-tax income towards his debt rather than 20% means Gary only pays $3,671.74 in interest costs and gets his debts paid off more than a year and a half earlier, in 39 months.
| Total Debt Payment | Total Interest Paid | Time to Repay Loan | |
|---|---|---|---|
| Bi-weekly Payments ($700 per month) | $40,738.07 | $5,738.07 | 59 months |
| Bi-weekly Payments ($1,000 per month) | $38,671.74 | $3,671.74 | 39 Months |
| Difference | $2,066.33 | 20 months |
Paying off your debt as quickly as you can, while focusing on paying off those debts with the highest interest rate first can save you thousands of dollars in interest expenses. Automatically setting aside money as soon as you receive your paycheque will allow you to pay your debts off more quickly and get you into the habit of saving money each month so you can start earning compound interest rather than paying it.
