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.

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.

Background
According to Statistics Canada’s Survey of Financial Security :
 * 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%. At the end of 2014, the overall ratio stood at 163%. The ratio reached 175% in the first quarter of 2020. 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%.

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). Also, some of the mortgage debt consists of home equity extraction (mortgage refinancing) to finance consumer spending. According to the Bank of Canada ,
 * “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". According to the same survey, 84% of respondents said "getting out of debt is my top financial priority".

The following quote is from Alexandra MacQueen, certified financial planner and Financial Wisdom Forum member:

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.

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!

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 : 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.

Buy now, pay later
Also known as a deferred payment plan, these programs are marketing schemes at best. If you think that the company is allowing you to delay your payments free of charge, think again. There may often be fees to defer the payment.

Additionally, the company is counting on you to miss a payment. When that happens, you could be paying an annual interest rate of 28% to 30% and will accrue from the day of purchase - not from the missed payment date.

Instead, take that same payment amount and "pay yourself" by saving the money as part of your household budget. When you've saved up the total amount, then pay for it with cash. The result will be a lower total cost, and you won't be penalized if you miss a payment.

If you really need a big-ticket item that can't be paid for with cash, consider taking a line of credit, which will likely have a lower interest rate.

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. 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.

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?