Managing debt
Managing debt, or responsible borrowing, can help build a good credit history but overuse of credit to spend beyond your means can create problems and should generally be avoided where possible. “Good debt” is sometimes used to describe types of borrowing that can help improve your overall financial health over time. For example, a student loan to help pay for education can pay off by helping you get a job with a higher income.[1]
On the other hand, borrowing to buy things that you consume or that have only short-term value is generally considered “bad debt.” For example, going into debt for a vacation means that you will be paying for this long after you have enjoyed the short-term benefits.[1]
Background
According to Statistics Canada’s Survey of Financial Security[2]:
- 19% of households had lines of credit in 2019, up from 15% in 1999. The median line of credit debt was $16,000 in 2019, compared to $7300 in 1999.
- 30% of households had a vehicle loan in 2019, up from 21% twenty years earlier. The median amount owed was $18,000 in 2019, up from $13,200 in 1999.
- 37% of households carried an outstanding balance on their credit cards in 2019. The median amount owed was $3000.
Clearly, avoiding such debts is difficult for many Canadians, and the problem has been worsening. In 1980, the overall ratio of household debt to personal disposable income was 66%.[3] At the end of 2014, the overall ratio stood at 163%.[4] The ratio reached 175% in the first quarter of 2020.[5] At the extreme end of the spectrum, the proportion of households with a debt-to-income ratio greater than 350% doubled from 2005 to 2014, going from about 4% to 8%.[5]
The majority of household debts are in the form of mortgages, but in 2012, about 30% of the debt was consumer credit (lines of credit, credit cards, personal loans, car loans, etc).[6] Also, some of the mortgage debt consists of home equity extraction (mortgage refinancing) to finance consumer spending.[7] According to the Bank of Canada[6],
- “significant gains in house prices, which have raised the amount of home equity against which households can borrow, have encouraged strong growth in secured consumer borrowing (HELOCs). Also driving consumer credit is financial innovation, which has expanded the range and marketing of credit products, making them more appealing and accessible to households”.
Getting out of debt
According to a 2019 survey, "nearly half of Gen Xers said they’re “skeptical” they will ever be debt-free, compared with two-fifths of Millennials and one-third of Boomers".[8] According to the same survey, 84% of respondents said "getting out of debt is my top financial priority".[8]
The following quote is from Alexandra MacQueen, certified financial planner and Financial Wisdom Forum member:[5]
If you want to maximize your financial peace of mind and protect yourself from the risk of being unable to meet your debt obligations over time, you could minimize borrowing while prioritizing paying back any existing debt.
Getting out of debt typically requires a plan, ideally a written plan. Which debt will be paid first, how much per month will you pay, when will you be debt-free, etc. The typical advice is to pay the highest interest debt first, often a credit card.[9]
The FCAC offers advice on Making a plan to be debt-free and the Ontario Securities Commission suggests Strategies to pay down debt.
If you need additional help coming up with a plan, you could consider hiring a "money coach" or a credit counselor.
Avoiding "bad" debt
The following sections give some ideas on thinking long-term; this is the best way to avoid "bad" debt.
Emergency fund
People sometimes get into debt because of an unexpected life event such as loss of employment, etc. An emergency fund is a cash reserve that allows you to face such events without getting into debt or having to sell long-term investments.
Household budget
If you tend to spend more than you earn, you may need a household budget to stay out of debt and save money for goals such as retirement, a down payment on a home, holidays, or big purchases.
Car loans
Cars are expensive, so you will probably need another car loan when the current car is paid off, or when the lease agreement ends, right? Doesn’t everybody have a car loan these days anyway? There are better, less expensive ways. The old-fashioned idea is to pay cash for your next car, instead of taking a loan. Paying cash will typically require saving regularly in order to reach this goal. If the amount needed to pay cash for your next car seems too much, maybe you should not be purchasing a brand new car, or you should select a less expensive model![10]
A home you can afford
Whether you choose to own a home or rent it, paying more than you can afford on housing will strain your finances, and could make it more difficult to save money every month and avoid debt.
Home renovations can be expensive endeavours. While renovations can increase your home resale value, the resale price increase is typically less than 100% of the cost of renovations, and for some projects is less than 50%. Financing renovations through debt (typically through increased mortgages or HELOCs) may encourage the homeowner to spend more than if renovations were paid for with available cash.
Credit cards
If you are paying your credit card balance in full each and every month, and you are avoiding cash advances, you are using your card wisely[11]: the credit card company is supplying you with the equivalent of one month of expenses interest-free, and you may be getting cash back or travel rewards from using your card.
But buying stuff with your credit card that you don’t have the cash to pay for spells trouble later. If you find yourself doing that, maybe a debit card is a better choice, or even actual cash. Some people use jars with predefined amounts of cash for specific budget items.[12]
Buy now, pay later
Buy now, pay later (BNPL) is a short term financing option to purchase goods or services. It is a type of unsecured consumer credit.[13]
The original form of BNPL is the deferred payment plan, typically used for more expensive purchases like furniture or home appliances.[14] Recent technological innovations in the BNPL space have allowed it to apply to online purchases, including for small items.[15] BNPL may also be offered in store.[14]
The basic issue of BNPL plans is that they allow you to make purchases you may not really be able to afford, including impulsive purchases not planned in your budget. Over time, this can lead to spending more than you earn, an increased debt load, and lower (or negative) net worth. The FCAC writes that "psychological and behavioural biases ... may make BNPL products and services attractive to consumers".[14] I.e. the pain of paying comes later and is disconnected from the instant gratification of the purchase.
The alternatives to BNPL plans are saving the money first, for large purchases, and buying only what you afford this month, for smaller purchases.
Personal loans, lines of credit
Personal loans are a type of loan in which a borrower gets a fixed dollar amount and agrees to repay that amount plus interest over a fixed period of time.[16] A line of credit is a type of loan that lets you borrow money up to a preset limit. You can use the funds as needed, up to a specified maximum and pay the loan back at any time. You are charged interest from the day you withdraw money, until you pay the loan back in full.[17]
Before you take a personal loan or draw on a line of credit, ask yourself if you really need the money now. Can the purchase wait? Is that purchase wanted or needed? Why not save for it?
See also
References
- ^ a b Financial Consumer Agency of Canada, Good debt and bad debt, viewed January 17, 2020.
- ^ Statistics Canada, Assets and debts held by economic family type, by age group, Canada, provinces and selected census metropolitan areas, Survey of Financial Security, Table: 11-10-0016-01 (formerly CANSIM 205-0002), viewed January 11, 2021
- ^ R.K. Chawla and S. Uppal, Household debt in Canada, Statistics Canada, Perspectives on Labour and Income March 23, 2012, viewed March 21, 2015
- ^ G. Marr, Canada household debt ratio hits new record of 163.3%, National Post, March 12, 2015, viewed March 21, 2015
- ^ a b c Alexandra Macqueen, Canada’s climbing debt-to-income ratio: what you need to know, MoneySense, December 3, 2020, viewed January 11, 2021.
- ^ a b Bank of Canada, Household spending and debt, December 2012, viewed March 21, 2015
- ^ Bank of Canada, Household finances and financial stability
- ^ a b Sandra E. Martin, Who’s afraid of big, bad debt?, MoneySense, November 21, 2019, viewed January 11, 2021.
- ^ Financial Consumer Agency of Canada, How to beat that debt, viewed January 11, 2021.
- ^ L.F. Dogu, Five ways to get off the car loan merry-go-round, Forbes magazine online, The Bogleheads® view, October 8, 2010, viewed March 18, 2015
- ^ Financial Consumer Agency of Canada, Be smart with your credit card: Tips to help you use your credit card wisely, viewed March 21, 2015
- ^ G. Vaz-Oxlade, The “Magic” Jars, viewed March 21, 2015
- ^ Corportate Finance Institute, BNPL (Buy Now, Pay Later), Updated January 18, 2023, viewed March 6, 2023.
- ^ a b c Financial Consumer Agency of Canada, Pilot Study: Buy Now, Pay Later Services in Canada, modified November 18, 2021, viewed March 6, 2023.
- ^ CPA Canada, Be cautious when using Buy-Now-Pay-Later for online purchases, October 29, 2021, viewed March 6, 2023.
- ^ Financial Consumer Agency of Canada, Personal loans, viewed October 21, 2021.
- ^ Financial Consumer Agency of Canada, Lines of credit, viewed October 21, 2021.
External links
- "Managing debt - Planning basics". GetSmarterAboutMoney.ca.
- Gail Vaz-Oxlade. "Why Are You In Debt?". Archived from the original on 2017-12-14.
- Gail Vaz-Oxlade. "How much is your debt costing you?". Archived from the original on 2018-12-03.
- David Hodges (January 9, 2017). "To conquer debt, get out of your head and create a written financial plan". The Globe and Mail.
- "What you need to know about debt and how to manage it". The Globe and Mail.
- "Managing debt: Snowball vs. avalanche, consolidation, bankruptcy and more". The Globe and Mail.
