Debt: What It Is and How to Handle It
A debt is money owed by one person or entity to another.
You get into debt by borrowing money with the agreement that you will pay it back, often by a certain date.
Usually, debt also incurs interest, a percentage of the amount borrowed. Interest is paid to the lender, and it can make your total debt more expensive than the amount you borrowed. Interest charges are an incentive to pay off your debt as quickly as possible.
Is debt always a bad thing?
Ideally, you don’t want to have to deal with debt.
That said, a debt-free life isn’t a reality for most people. Life is expensive, and some purchases exceed the cash we have in savings. In order to pay for them, we need to borrow money.
Most Canadians have some sort of debt during their lives: student loans, maybe credit card debt, or even a mortgage.
While it’s a good idea to avoid too much debt, debt can sometimes be a tool to help you achieve your long-term financial goals.
Good 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.
Bad debt
Bad debt is money borrowed for things that will depreciate in value over time. For example, credit card debt and car loans are sometimes 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.
Keep in mind that the terms good and bad debt are relative and subjective.
Depending on your circumstances and cash flow, debt that might initially be considered good or bad could get reclassified. 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 commute to a higher paying job might qualify as good debt.
How long does debt last?
Debt persists until it is paid off, or until the borrower declares bankruptcy.
To avoid serious financial consequences, debt must be repaid according to the terms and 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 order to recover the money owed. 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.
Can I inherit someone else's debt?
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.
How do I understand the severity of my debt?
Debt-to-income ratio is a common formula used to figure out how much debt your household carries in relation to your net income.
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 your monthly income can cover your debts with something left over.
However, a debt-to-income ratio of 43–49% is concerning, and a ratio of 50% or higher is likely to be problematic.
Once I'm in debt, how do I pay it off?
The best way to pay off debt depends on the type and amount.
Fixed payment loans typically have set monthly payments. If you make each payment on time and in full, you'll pay off the loan completely in the timeframe stated in your loan agreement — such as 36 months or 25 years.
Revolving debt, such as credit cards or lines of credit, work a bit differently. With these debts, it can be easier to borrow more than you can pay off in a month, and interest rates keep your balance climbing higher each time it rolls over to a new month.
Two common strategies to pay off larger amounts of high-interest debt are the snowball method and the avalanche method.
Snowball method
Make a list of all your debts in order of the size of the balance.
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 move on to the next-smallest balance.
Repeat this process until all debts are paid.
Avalanche method
Make a list of your debts in order of the interest rates.
Pay the minimum payment on all your debts, except for the one with the highest interest rate.
Pay as much money as possible toward your highest interest debt each month, so that it's paid off as rapidly as possible.
Once your highest interest debt is eliminated, use the amount you were paying toward it to start tackling the next debt on your list.
Both of these strategies can be 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.
Seek relief for overwhelming debt
Dealing with debt can be stressful. Don't be afraid to ask for help from a professional debt counsellor. They may be able to assist you with other options, like 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.
Not all debt relief and credit counselling agencies are legitimate; some can be predatory. Be careful when signing up for any debt management plans. This resource from the Government of Canada can help you find a reliable and credible credit counsellor near you.
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