A client phoned me and asked if we could meet the next day. I immediately agreed, because it’s been a couple years since we’ve spoken. In the past, she has declined my invitations to meet. I asked her what she would like to discuss, and she asked me to be prepared to explain options for taking income from her LIRA (locked in money from a pension account). Knowing that she’ll soon be 65, I hoped it would be an optimistic meeting about when and how she might be able to retire.
That wasn’t the case. When we met in my office, she explained that she had accumulated $27,000 in credit card debt. She realised that, even making monthly payments of $500, she wasn’t making any progress, since the interest rate is 19%. Her plan, although not her ideal solution, was to make a withdrawal from her RRSP to pay off the debt. This struck me as unsavory, so I asked some questions about how the debt accumulated and what other options she had already explored.
Her husband worked for himself. They lived on two incomes, until he broke his shoulder. She was quick to point out that it happened while he was rescuing his granddaughter from a runaway horse, a potentially deadly situation. Although his sacrifice was heroic, he hasn’t been able to work for the last nine months. I had assumed that anyone who found themselves with less income would reduce their level of spending, but it turns out I was wrong. They lived on a lump sum of cash he had received from a business venture and on credit card spending. It wasn’t until the debt was out of control that they came to me.
What options do they have? Being self employed, he had no pension or RRSP savings. She had some pension savings from a previous job, but since she’s still working, she’ll incur a large tax bill when taking it out. I asked what else she had tried. She called the credit card company and tried to negotiate a lower interest rate. They replied that since she wasn’t making any progress on her debt, only paying the interest, that they wouldn’t lower the rate. She went to the bank to get a consolidation loan, so that with a lower interest rate, she could make some real progress against the principal. The bank looked at her high level of credit card debt (and probably relatively low level of income) and refused the loan.
Because she had already tried other, more reasonable, options and because there was real urgency, I agreed to send money from her retirement account. It’s important to be clear that she will not be able to retire on the investments she has left. But if she doesn’t make this withdrawal, she may have bigger problems to worry about, like bankruptcy. Because the money was in an Alberta LIRA, we converted it to a LIF and exercised the 50% unlocking option, funding the RRSP. We had to sell $33,000 of investments to provide $23,000 of cash, since 30% tax will be withheld. Even so, she may end up with a tax bill at the end of the year. The result is that she’ll be left with $4000 credit card debt. Maybe she can renegotiate a lower interest rate, but even if not, she should pay it off in nine months, paying $500 per month.
After the credit card debt is repaid, I’ll encourage her to start funding her RRSP each month using the $500 that had been going to debt repayment. This will have the benefits of increasing her retirement funds, reducing her taxes and keeping their monthly spending low. The lower their monthly spending, the easier it will be to retire. If they have to depend on government programs, even if they both qualify for full CPP and OAS, they can only count on about $2700 per month, taxable.
What could they have done differently? What do you need to do to avoid a similarly sticky debt trap? I have three suggestions that apply to everyone. First, apply for a line of credit at the bank. If you have equity in your home, the bank will probably offer a lower interest rate. In any case, an interest rate lower than what a credit card would charge is acceptable. (Do not apply for credit insurance, which benefits the bank, not you.) If you never draw on the credit, the line of credit should cost you nothing. If you find, one month, that you are not able to pay off your credit card entirely, you will be able to draw funds from the line of credit and save yourself from incurring higher interest costs. One caveat: interest compounds on the line of credit. The second suggestion is to build up an emergency fund. Three to six months of living expenses, in a savings account, will help smooth out any period of low earnings or a break in income. The final suggestion is to see that, if you are working, you have disability insurance. Most benefit packages include adequate coverage, but self employed workers often go without. There is a cost, but it mitigates the risk of earning nothing while not being able to work. With a cash reserve, you can reduce your disability insurance cost by lengthening the waiting period. And, as you progress toward financial independence, you can reduce the benefit amount. Taking these steps BEFORE finding yourself in a sticky situation will make it easier to survive what could be a difficult period.