Avoid your own personal debt ceiling

The global economy may have temporarily dodged a bullet with the 11th-hour raising of America's US$14.3-trillion debt ceiling, but individuals should draw some salutary lessons for their personal financial health.

The Bank of Montreal has issued five tips on how individuals can avoid hitting their own personal debt ceilings.

Like Washington, one in three Canadians live beyond their means, with 27% living paycheque to paycheque - a 10% increase over last year. Individual Americans are in just as precarious a spot, with the average household carrying US$75,600 in debt and 44 million relying on food stamps.

BMO's first two tips could apply both to the U.S government as well as citizens of eithercountry: don't overspend and curb credit card debt.

These are obviously related. Both at government and individual levels, overspending increases debt. It's taken Uncle Sam decades of profligate spending to reach this crisis, but the average citizen can get into credit card trouble far more quickly.

Government has two advantages. First, the interest it must pay on government bonds is less than the doubledigit rates consumers are charged on retail credit cards. Second, governments can raise their own credit limits: the United States has done this 69 times since 1962. The current crisis is unusual only because a political impasse prevented the normal rubber-stamping of raising the ceiling.

Individuals who hit their credit card limits should take it as a sign their discretionary spending is out of control and start cutting back. Or they can emulate governments by raising revenues. Employees can't do this by increasing taxes, but they can raise revenues by getting a raise, finding a betterpaying job, moonlighting or running a business on the side.

The trouble starts if you maintain or increase spending without boosting your income. Too often, indebted consumers do just what Washington has done and ask their financial institution to raise the limit on their credit card. However unwise this is, the request is often granted because that's how the banks make their money.

But even if your card issuer does you a favour by refusing to raise your limit, debtors hellbent on their ultimate financial destruction may apply for second and third cards, bypassing the safety mechanism of hitting the limit on the first card.

Problems snowball if you pay only the suggested monthly minimum payment. The power of compound interest goes in reverse and you get in over your head - drowning if unexpected job loss curtails your ability to meet even the seemingly low monthly minimums.

Another BMO tip is become mortgage-free faster. This tip comes after curbing credit card debt, since mortgage interest is much lower than that charged by most credit cards. Credit card debt is considered bad debt because it involves spending on consumption. Mortgage debt is good debt because it helps you build equity while putting a roof over your head, and is tax-deductible for Americans. You have to live somewhere, but renting means paying off your landlord's mortgage, not building equity in your own home.

The problem is mortgages are front-loaded to consist mostly of interest payments in the early years, rather than principal. But that's only if you play it the banks' way and drag out your mortgage over 20 or 30 years. It's analogous to paying only monthly minimums on credit cards.

If the mortgage is large and monthly payments small, you'll pay more in interest than the house cost, meaning your effective home price is double or triple the asking price. The best mortgage is no mortgage at all and the way to eliminate one is to have high regular payments that reduce significant amounts of principal from day one. Take advantage of annual prepayment privileges (often 10% or 15% of outstanding principal) and you'll be amazed how fast your personal debt ceiling fades into irrelevancy.

Once credit card and mortgage debt are eliminated, along with student loans and car loans, focus on becoming the beneficiary of compound interest instead of its victim. BMO's fourth tip is invest to save, ideally through the new tax-free savings accounts.

The last tip applies to individuals or Washington: have a Plan B. Unfortunately, too often the B stands for bankruptcy. This is invariably a disaster for consumers and as the world almost discovered the past week, a disaster for everyone if the government of the world's largest economy goes bankrupt.