Deep in debt with a baby on the way
Q. My wife and I are expecting our first child in a few months. We currently have a combined income of about $150,000, but we are not sure how we are going to manage financially while she is on maternity leave. By our calculations she will not receive the maximum EI benefits when she’s on leave. We are carrying $19,000 in credit card debt and have been putting $1,300 every two weeks towards it, but that is not going to be an option once the baby arrives. I wonder if I should use the $24,000 I have saved in RRSPs to get rid of this debt. By wiping out our credit card debt, we’d free up about $400 from our monthly expenses. Is this a smart idea?
A. This is a terrible idea. Terrible.
I like that you’re thinking outside of the box and working on getting your financial house in order before your baby arrives. But selling your RRSPs to pay down credit card debt is not the way to do it, for two main reasons: Math and discipline.
Cashing in RRSPs will trigger a big tax bill
I understand your thinking. You have a big credit card debt in one hand and more than enough money to eliminate it in the other hand. Except for one problem. That money is sitting in an RRSP and if you cash it out you will trigger a big tax bill. Basically, the government will say that you have earned that $24,000 as income and will tax you on it, just as if you got a juicy bonus at work.
For simplicity, let’s say your marginal tax rate is 40%. That means you’ll pay $9,600 when you file your income taxes, leaving you with just $14,400 to go towards the credit card debt. Put another way, you’ll incur a huge tax hit and you still won’t have enough money to pay off the debt.
Compound interest turns pennies into gold
I know it is going to be tough to leave the money inside your RRSP, but don’t think of it as just $24,000, think of it as $194,000. Because that is what it will be worth if you leave it in there and let compound interest turn those pennies into gold at 6% for the next 35 years.
Sure, your credit card debt is costing you more in interest than you are earning on your RRSP investments—probably 25% versus 6%. But the compound interest calculation underscores the importance of letting your retirement savings grow and finding another way to eliminate the bathtub full of credit card debt you’re dragging along with you.
Having a baby isn’t an emergency
I can understand why some people have no other choice other than to cash out their RRSP. They are dealing with some sort of health or family emergency and this is their last resort. A new investment opportunity is not an emergency and neither is having a baby. Your plan doesn’t make mathematical sense and it undermines the discipline of saving for your retirement.
You make good money as a family and while these next two years are going to be lean financially, you will be able to get back on track much faster than someone who earns less. While it is stressful, take the long view. Stay disciplined and protect your retirement savings.
Now that you’ve heard my sermon on protecting your RRSP, here are two actions I suggest you take to help you improve your situation.
Try to find another lender
I get a little nauseous thinking of you paying 25% interest on your $19,000 credit card debt, so I can imagine how upsetting that must be for you every month. Try to find another lender that will change you a lower interest rate and consider finding a new low-rate card. Even if you have already tried to do this, try again.
Take your pregnant wife with you to the bank. Your combined household income is very good and banks have some latitude to make exceptions. Ask them what your options are? Do you qualify for a loan for even part of the total amount? Can you use your home to secure a line of credit? Is there a family member you could ask to co-sign a loan at the bank? Could that family member lend you the money directly?
Exercise restraint on baby spending
I know you’ll probably roll your eyes with this one, but I recommend you exercise restraint on baby spending. Sure, it can be really expensive. But for the most part, it doesn’t have to be, especially in the first year. You will not need $400 a month for baby expenses.
As the father of a three-year-old I have been subjected to the intense marketing and societal guilt that is focused on new parents. You and your wife may want lots of things for your baby in its first year, but there is very little that you actually need: A crib, a car seat, some onesies and diapers. Most of this stuff can come from the local thrift shop, online sites like Kijiji, or friends and family.
Build up cash reserves now
Even if you can’t get a line of credit or a low-interest credit card from another lender, you still have options. First, the good news is you have a time before the baby is born. If you’re really worried about meeting your debt obligations then consider making only the minimum payment on your credit card debt, starting now.
While it will cost you more in interest, this will ensure you will be able to cover the minimum payments on your credit card for almost a year. While this may sound counterintuitive, it will give you the breathing room that you need. It will allow you to build up a cash cushion to help you to avoid taking on any additional debt and give you time to see how your costs add up. You may even find you’ll be able to increase your debt repayment sooner than you expect.
I would also look at what else you could cut from your spending now: Cable, cell phones, movies, eating out, etc. As you will soon discover, you can’t build up your reserves on sleep, but you can build up your reserves on cash.
Enjoy the ride.