Get a grip on debt
If you’ve done any amount of living, there’s a good chance you have a certain amount of debt in your life. You might have car loans, student loans, a mortgage, credit card balances—the list goes on. Depending on the size of your debt, the emotional burden can feel overwhelming. So how do you cope? A good place to start is by realizing that not all debt is bad.
Understanding good and bad debt
When managed responsibly, some debt is considered good and can even help to boost your credit score. Loans that help improve your life are viewed favourably by other potential lenders; however, this is true only if you reliably pay them off in a responsible and timely manner. The following types of debt can be positive—if you borrow within your means.
Car loan: You need a car to drive to work, haul your kids around to their activities, and cart home groceries for the family. So you visit the vehicle dealership, pick out a model that fits your price range, and then agree to the terms of the loan—paying back so much every month at a set interest rate over a specific period of time.
A car loan can be good debt because it helps you stay employed, which earns you money to pay back the loan, while also taking care of your family. It can also be bad debt if you take on more than you can afford. Before agreeing to an automobile loan, it’s important to carefully consider your household budget and what you can realistically afford to pay each month. While the latest model SUV might be very tempting, the older sedan might do the job and be a bit more affordable.
Student loan: Given the high cost of postsecondary education in Canada, it’s fairly typical for people to take out a student loan to help pay their way through school. A student loan can be considered good debt since educating yourself can strengthen your future job prospects and earning potential. However, student loans have the potential to become bad debt if you have trouble paying them off. New graduates starting out at a lower rung on the salary ladder may also feel heavily burdened by a sizable debt that can take years to eliminate.
Mortgage: A home purchase comes with a hefty price tag that most people can afford only with the help of a mortgage. This can be considered good debt because of the possibility that the value of the home will appreciate over time. Yet there’s potential for a mortgage to become bad debt if you can’t keep up with payments.
With rising inflation, interest rates are also moving higher, meaning that the affordable mortgage you signed on for just a couple of years ago may be quite pricey at renewal. Check out this article to learn more about mortgages and inflation.
It’s important to examine your budget, borrow only what’s manageable, based on your earnings, and understand your options. For instance, a flexible mortgage lets you pay down debt at your own pace and adjust or even stop regular payments for a period of time if your situation changes—as long as you don’t exceed your borrowing limit.
Caution
Take a cautious approach when considering any sort of borrowing, but especially with loans that can trap you into a debt cycle.
A payday loan is an advance against your next paycheque. Companies offering this type of service will provide a short-term loan based on proof of income, such as a pay slip. You tell the lender how much you wish to borrow; the money is provided and repayment in full is expected on the loan due date, along with a fee for borrowing the funds. If you can’t repay in full, then you have the option to extend the loan and pay more fees. Once in this debt cycle, it can be difficult to escape. Fees can range from 15% to 30% of the amount borrowed.
Using a credit card can be a convenient way to make purchases, but discipline is required. The best strategy is to pay off your balance each month to avoid interest charges. And if you run a balance month over month, it’s important to make the scheduled payments. The penalty for a missed payment can be a higher interest rate on borrowed funds, as high as 30% in some cases. If you’re carrying a balance, focus on paying back the money as quickly as manageable given your household budget. It can take a very long time to bring the balance back to zero when only making minimum payments, and during that time you'll pay a whopping amount of interest.
If you find yourself in a debt cycle, speak to your advisor and work together to figure out next steps. When debt builds, stress also increases. Don’t wait to seek help until you’re struggling to balance all your household expenses.
Moving forward
Paying back debt requires a bit of planning and strategy. The first step involves budget planning to make an honest assessment of your cash flow. Check out this article on household budget essentials, and use this budget planner worksheet to help you track everything in one spot.
Once you identify all your expenses, various loans, and credit card debt, you can figure out the best way to get started. This is where your advisor can help steer you in the right direction. Set up a meeting to talk about your financial obligations and debt consolidation—professional guidance is a smart idea!
Repayment strategies vary, but there are two methods that can help to make a dent in your debt—the snowball and the avalanche.
Snowball method
Just like building a snowball, you start off with the smallest debt and gradually build up the big stuff:
- Make a list of your debts, from smallest balance to largest, regardless of interest rate.
- Make the minimum payments on everything, except for the smallest amount you owe.
- Focus your efforts to pay off the smallest debt on your list as quickly as you can manage, then move to the next smallest debt.
Enjoy a sense of accomplishment by paying off the smallest debts first, building momentum for tackling the bigger debts.
Be aware of this snowball drawback: Focusing on the smallest debt first rather than the debt with the highest interest rate means you’ll pay more in interest over the long term.
Avalanche method
This method of debt reduction focuses on paying off the highest-interest debt first.
- Make a list of your debts ordered from the highest interest rate to the lowest, regardless of the amount you owe.
- Make minimum payments on all debt but target as much as you can afford toward the debt with the highest interest rate.
- As you pay off one debt, target the next item on your list.
Focusing on the debt with the highest interest rate first is the least expensive way of becoming debt free.
Be aware of this avalanche drawback: Avalanche debt repayment may feel slower and less exciting than the quick-win gratification that comes with the snowball approach. Determine which method is more likely to keep you motivated and on track.
The good, the bad, and how to pay it off
Regardless of your method for knocking down debt, it’s important to take an honest look at your spending habits versus your earnings and create a household budget. Then consult with your advisor on the best way forward and look at where you can reduce costs.
For more helpful information about money management, check out this Solutions article, which offers helpful advice for getting your household budget on track.
Important disclosures
The commentary in this publication is for general information only and should not be considered legal, financial, or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation.
