As we’ve seen, debt can be useful and even instrumental in building wealth. But debt comes with certain risks, and if not handled carefully, it can do far more damage than good.
Here are a few example scenarios:
- Adam took out a $20,000 car loan, certain he’d be able to pay it off in a few years, as he’s financially stable and has a steady job stocking a warehouse. Then he gets into an accident and can no longer work. Now he has no income and has to cut expenses. While he recovers and transitions to a different type of job, his interest is increasing every day and he’s not making payments.
- Sam and Alice have a $400,000 mortgage with a variable interest rate. For several years, the rate remained at around 6%, and Sam and Alice had no trouble making repayments. Then it shot up to 12%. Now they’re not sure they can afford to keep the house.
- Madison invested $100,000 of her own capital plus another $100,000 she borrowed. She did her research and chose her investments carefully, but then the market crashed. Now, her returns are far below what she expected, and she’s afraid she won’t be able to pay back the $100,000.
While the market is highly unpredictable and investments always carry some level of risk, there are things you can do to shore up your finances against personal emergencies and economic downturns.
Let’s look at what each of these people could have done to avoid the situations they’re in now—or, in one case, what they can do now to get out of that situation.
Adam: income protection insurance
Adam couldn’t have predicted that he’d get into an accident and lose his ability to do heavy lifting. But he could have realised that loss of income due to illness or injury is a common problem, and knowing that, he could have purchased income protection insurance.
If he’d had income protection insurance, Adam would have received regular payments of up to 70% of his pre-accident income, until he either returned to work or the policy term ended. While he may still have had to cut some expenses, he might have had enough to continue making repayments on his loan, especially if he’d had other savings to draw on.
Luckily, Adam will probably be able to work again in a different capacity. However, if he’d ended up completely disabled and unable to ever work again, he might have benefited from TPD (total permanent disability) insurance. In this case, he would have received a single lump sum to replace his income, which he could then use to fund medical expenses and pay down debts.
Another option is trauma insurance, which pays the insured a lump sum in the event of a life-threatening illness or injury. Again, this doesn’t apply to Adam’s current situation, but if he were to develop a condition such as cancer or kidney failure, trauma insurance would help him cover debts and medical expenses.
Learn more about the different types of insurance you can use to protect your income.
Sam and Alice: fixed interest rate
Sam and Alice couldn’t have known that their interest rate would double, but they knew when they signed the loan agreement that their interest rate was variable, and therefore subject to change.
There are advantages to having a variable rate. A fixed interest rate tends to be higher, and if you choose a variable rate, you may get an initial period where your interest rate is especially low.
But a fixed rate is easier to budget for because it’s a fixed expense: you always know how much it will be, and if you allocate enough for it in your monthly budget, you should be set.
Sam and Alice could have told their mortgage provider that they wanted a fixed interest rate, or they could have shopped around until they found a lender willing to offer a fixed rate.
Madison: options for getting out of debt
Obviously, when making an investment, you’ll want to do your research and maybe even talk to a financial advisor or investment manager before making a decision. Madison’s case is tough because she did her due diligence beforehand and still ended up with a debt she can’t repay.
So, if you find yourself in debt with no foreseeable way out, what can you do? Here are a few options.
- Ask for help
Sometimes, you just can’t do it on your own. Many financial counsellors offer free, independent, confidential services to help you deal with unmanageable debt. Call the National Debt Helpline at 1-800-077-077 to get in touch with one.
- Talk to your creditor
You’re not the first person who’s ever defaulted on a loan. Many lenders have hardship programs designed specifically for those in your situation. These programs may give you more time to pay, provide you with a more flexible payment option or allow you to settle the debt with a smaller payment than originally agreed on.
- Know your options
If you’re truly unable to pay back your debts, you may think there’s nowhere to go from here, but that’s not true. There are a few things you can do:
- Make a debt agreement
If you can’t afford to pay all of your debt, you may be able to negotiate with your creditors. Under a debt agreement, you agree to pay a percentage of your debt over a certain period of time. After you pay the amount specified in the new agreement, your creditors can’t take any more. To make a debt agreement, you’ll usually need to talk to a registered debt agreement administrator, who can submit a proposal to your creditors on your behalf.
- Make a personal insolvency agreement
Under a personal insolvency agreement, an appointed trustee takes control of your assets and makes your creditors an offer to pay at least part of your debt via a lump sum or instalments. Before making this type of agreement, talk to a financial counsellor for advice.
- Get temporary debt protection (TDP)
If you can’t repay your debt and are being threatened with property seizure, you can apply for TDP and get 21 days of protection. During this period, creditors can still contact you, but they can’t seize your goods or garnish your wages in payment of your debt. You can use this protection period to get advice from a financial counsellor, negotiate with your creditors and consider your options.
- Declare bankruptcy
Because declaring bankruptcy will damage your credit score for at least 7-10 years, making it hard or even impossible to borrow in the future, it should never be your first choice. Rather, it’s something you do after you’ve exhausted every other option: when you have large debts you can’t repay, are behind on your mortgage and facing foreclosure or keep getting phone calls from bill collectors.
When you declare bankruptcy, a court-appointed trustee may sell some of your assets to pay down your debts. After this, your debts are considered discharged, even if they’re not entirely paid off. Or, the court may approve a plan in which you’ll repay part or all of your debt over 3-5 years.
Managing debt includes managing the risks associated with that debt. Purchasing insurance, fixing your interest rates and choosing your investment strategy carefully can all help you offset the risks involved with going into debt. And if worst comes to worst, it’s important to know your options.
Learn more about managing financial hardship.
