In the simplest of terms, debt is money owed by one person or entity to another. You get into debt by borrowing money from someone under the condition that you will pay it back, often by a certain date.
Usually, debt also incurs interest, a percentage of the amount borrowed. The interest offers a benefit to the lender, and it’s an incentive to pay off your debt as quickly as possible.
Ideally, you don’t want to have to deal with debt. Avoiding it as much as possible helps you save money since you’ll often be charged interest on top of the amount you borrow.
That said, a debt-free life isn’t a reality for most people. Many of us will have some sort of debt at some point: student loans, maybe credit card debt, or even a mortgage. While it’s a good idea to avoid debt as much as possible, not all debt is considered equal. Debts are commonly divided into what is referred to as “good” debt and “bad” debt.
Good debt is any debt that will add value or increase your net worth. For example, student loans and mortgages are considered to be good debt. Your student loan can help you qualify for a job and, ideally, earn a higher income throughout your career. And generally speaking, the value of the home you’ll buy with a mortgage will increase over time.
On the other hand, bad debt is money borrowed for things that will depreciate in value over time. For example, credit card debt and even a car loan are considered to be bad debts. These types of loans often have higher interest rates. For example, the majority of credit cards charge 19.99% interest.
Depending on your circumstances, debt that would usually be considered good or bad could switch to the other category. A car loan for a luxury vehicle with high payments you can’t really afford would be bad debt, but a loan that helps you buy a used car so you can get to work might qualify as good debt.
Your debt does not magically go away if you ignore it. You need to pay it off according to the timeline you agreed on when you borrowed the money. If you cannot pay off your debt, you will likely be approached by a debt collector, who has a certain amount of time to take legal action against you. In Canada, each province has its own statute of limitations, which range from 2-6 years. This is a worst-case scenario and, ideally, you should pay your debt as soon as possible, working directly with your creditors, so you don’t have to deal with debt collectors.
Debt-to-income ratio is a common formula used to figure out how much debt your household carries in relation to your net income. Net income is the money you have left after you pay taxes, EI, and CPP or QPP, which may be deducted from your paycheque. This statistic is used on a national level to determine Canada’s financial health. It is also required on a personal level when you apply for a mortgage since the lender wants to ensure that you’ll be able to make your payments.
To figure out your debt-to-income ratio, divide the sum of your monthly debt payments by your monthly income. Then multiply the result by 100% to turn that number into a percentage.
For example, say you make $5,000 per month. You also have a $1,200 monthly mortgage payment and a $500 monthly car payment. This means you pay $1,700 toward debt each month.
$1,700 ÷ 5,000 = 0.34
0.34 x 100% = 34%
Since this is below 36%, it’s considered a good debt-to-income ratio, as it’s assumed you can manage your debt on that amount of income. However, a debt-to-income ratio of 43–49% is considered concerning, and a 50% or higher ratio is considered dangerous.
Paying off debt requires picking a strategy and sticking to it. Two common debt-payoff strategies are the snowball method and the avalanche method.
In the snowball method, you make a list of all your debts in order of the size of the balance. Then you pay the minimum payment on all of them, except for the smallest debt. Pay as much money as you can afford toward that smallest balance until you’ve paid it off. Then celebrate, and move onto the next-smallest balance. Repeat this process until you’ve paid off all your debts.
In the avalanche method, you make a list of your debts in order of the interest rates. Again, pay the minimum payment on all your debts, except for the one with the highest interest rate. Focus on paying it off first by putting as much money toward it as possible each month. Once you’ve paid it in full, celebrate — and then move down the list to focus on the one with the next-highest interest rate. Again, repeat until you’ve paid off all your debts.
Both of these strategies can be very successful, as long as you stick to them. The avalanche method will save you the most money over time since it minimizes the amount of interest you pay. But the snowball method offers quicker “wins,” which could help keep you motivated to pay off your debt.
Another option to consider is debt consolidation. If you have several debts and are having a hard time keeping track of them, you can consolidate them by taking out a loan and using it to pay off all the other debts. While you’ll owe a large total balance on this loan, knowing that you only have to make a single payment every month can help relieve some of the stress and anxiety caused by debt.
You can find a lot of helpful, free debt advice online through personal finance websites such as NerdWallet. Another option, which can help if you’re really struggling, is to visit a credit counsellor. Be careful to choose a legitimate company, as some companies that claim to help are actually scams.
This resource from the government of Canada can help you find a reliable and credible credit counsellor near you.
If you have ever wondered what happens to your debt when you die, know that it does not disappear. Secured debts, like mortgages and car loans, stay attached to your home or car. Your estate will need to pay them off, or your heirs will need to pick up the tab — or even sell the items to pay off the loans. Debts owed to the government, like taxes, also need to be paid out of your estate. Your credit card debt will also come out of your estate, but the issuer might simply write it off if there isn’t any money left. However, if you held a joint account with your spouse or partner, they will inherit that debt.
You should avoid accumulating any unnecessary debt, but you will likely have at least some debt at some point in your life, such as student loans or a mortgage. Remember the difference between good and bad debt, and try your best to avoid or pay off any “bad” debts as soon as possible.
Hannah Logan is a writer and blogger who specializes in personal finance and travel. You can follow her personal travel blog EatSleepBreatheTravel.com or find her on Instagram @hannahlogan21.