Understanding debt: making a debt management plan that works for you

July 15, 2022
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5 mins
Understanding debt: making a debt management plan that works for you
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Not every 4 letter word has to be bad, and debt is the perfect example. Debt in itself can be a tool in your financial portfolio when chosen carefully and managed properly. The simple truth is that for most Canadians, debt is unavoidable.

Canadians from all walks of life have debt. In fact, the average Canadian owes over $70,000, according to a study conducted by Equifax in 2020. This $70,000 in consumer debt is held in many different forms such as credit cards, student loans, and mortgages. 

The most important thing in managing debt is to understand it fully, ask yourself the right questions, and make an informed decision before you take it on. But what do you do if you’ve already gone down the debt rabbit hole before really understanding it? Well, whether you’re looking at taking on new debt, or trying to figure out how to manage your existing debt, we’ll give you simple, straightforward strategies that will enable you to manage your debt, and hopefully provide you with peace of mind.

What is debt? And the most common types you'll come across

Let’s take a moment to define debt and understand the different types of consumer debt that exist. In basic terms, debt is money owed from one party to another. The definition of it is easy enough to understand, but over time it has become so much more complicated than that. Gone are the days of I.O.Us, now are the days of complicated legal jargon and debt that spans over 30 years. 

There are 2 categories and 2 types of debt. Here’s what they are, how they work, and a few examples for each:

Categories:

  1. Secured debt 

Secured debt is a form of debt that requires some type of collateral (or security) to borrow against. Have you ever gone to borrow a towel from a gym and they ask for a piece of ID or your car keys? That’s a form of collateral, and also how secured debt works. 

Lenders lend against secured debt knowing that if the debt doesn’t get paid they can take ownership (or repossess) the collateral. Sometimes the collateral is sold to recover the amount owing.

Secured debt examples: mortgage, car loan, home equity line of credit (HELOC), secured credit card

  1. Unsecured debt 

As the name suggests, unsecured debt is the opposite of secured debt in that it does not require any collateral. Back to the gym example, some gyms offer towels as part of your fees and don’t require you to offer anything up when grabbing one. Ideally, they’d like you to return it, but sometimes you bring a towel home and that’s a risk the gym takes. 

Unsecured debt is higher risk for lenders, which is reflected in the interest rates you pay. Think of how much higher credit card interest rates are than a mortgage, this is because unsecured debt has a higher risk of loss to lenders. 

Unsecured debt examples: credit card, student loan, overdraft, payday loan

Types:

  1. Revolving debt 

Revolving debt can either be secured or unsecured, and has no set date on when it’s supposed to be paid off. It does have a minimum monthly payment equal to the interest owing, but you are under no obligation to pay off the principal amount as part of the minimum payments. 

This is the most flexible type of debt as it allows you to choose how much you want to borrow or pay off. If you want to close it out, you have the freedom to do that too. There are no penalties involved in paying off or closing these types of loans.  

Examples of revolving debt: credit card, HELOC, personal line of credit

  1. Term debt 

Term debt is revolving debt’s counterpart in every way. It has a set loan amount, timeframe to pay it back (term), interest rate, and penalty to close it out early. There is a principal amount owed (also known as the borrowing or loan amount) which is expected to be paid off in a certain amount of time. The monthly payments consist of principal plus interest.  

While this type of loan is not the most flexible, it typically holds the best interest rates, lets you know exactly how much your monthly payments are, and allows you to pay off the debt over time. These are generally for higher amounts than revolving debt and are used for larger purchases such as a car or home. 

Examples of term debt: mortgage, car loan, student loan

Debt types and examples

Good debt vs. bad debt: what’s the difference?

Isn’t all debt bad? The answer is no. Remember how we said at the beginning that debt can be a tool in your financial portfolio? This is at the heart of understanding the difference between leveraging debt and just taking on debt, or good debt vs. bad debt. 

With all debt not being equal, how do you decide if debt is good or bad? Sometimes it’s clear-cut and other times there is an “it depends” factor. 

The general rule of thumb is that if you are taking on debt to purchase an appreciating asset (one that goes up in value over time) then it’s considered good debt, if you’re taking on debt for a depreciating asset (one that goes down in value over time) then it’s bad debt. 

For example:

  • Good debt: taking on a mortgage

The ability to grow equity by buying a home is what categorizes a mortgage as “good debt”. There are two ways your home can increase in equity over time: increased value and debt repayment. 

Historically speaking, housing prices continue to go up over time. If you purchase a home for $350,000, and you can sell it for $425,000, then you have $75,000 in equity (or cash). 

Now, layer on your monthly mortgage payments over the years with that equation. Say  you’ve owned your home for 10 years, and over that time you’ve paid down $100,000 of your principal. Your mortgage amount is now $250,000. In this scenario, where you sell your home for $425,000, you actually have $175,000 in equity. The $75,000 from the increased value, plus the $100,000 you’ve paid into your mortgage.  

  • Bad debt: vehicle loans

If appreciation is the hallmark of good debt, then depreciation is the stamp of bad debt. A new vehicle is a prime example of a depreciating asset; in fact, there’s a saying, “the second a new car drives off the (dealership) lot it loses 30% of its value.” That’s a big hit. 

Taking out a loan to purchase a new vehicle that loses value means you’re never going to be able to pay off the debt with the asset (vehicle) you have, and you’re going to have to come up with the money to pay it off. Not to mention you’re paying interest on the loan too, which means you’re paying more for the vehicle than it’s worth. This is where living within your means comes into play, which we’ll tackle later in this article. 

  • “It depends” debt: student loans

Student loans are one of those debts that can fall into either the good or bad debt categories. Student loans can help you pay for rent, groceries, and tuition while you're in school, but use them recklessly and you can find yourself in trouble. Taking on more student loans than you need, not graduating, or not leveraging your degree once you graduate is when student loans fall into the bad debt bucket. 

Using the student loans you need to achieve your degree to work in a field that recognizes, (and pays) for that piece of paper is when student loans are considered good debt.  

Responsible debt management: debt is unavoidable, managing it properly is not

Debt is a part of Canadian lives, and with the average consumer debt being $70,000 per Canadian, we would argue it’s impossible to avoid. The trick isn’t necessarily to avoid debt, but to manage and leverage the debt you take on to help you get ahead in life. Responsible debt management really comes down to two things: limiting the bad debt you take on and managing it properly.

 

Limiting the bad debt you take on

Spending less than you earn seems like common sense (at face value). Perhaps that’s why “live within your means,” is considered by many to be the wisest  financial advice. But is it really the best advice? Or More importantly, is it even possible? How old is that saying anyways?

Did you know that it wasn’t until the 1900s when mortgages were offered by banks in Canada? Before then it was more of a rent-to-own scenario from the land owner, and no banks were involved. Back then it was near impossible to live outside of your means.

You’ll notice this section doesn’t say don’t take on bad debt, it says limit it. Intelligently choosing to get a car loan for a $5,000 vehicle that allows you to take a higher paying job outside of transit options is a sound decision. Deciding to get a car loan for a $70,000+ dream vehicle out of vanity is not. 

Managing debt properly

Do you know exactly how much debt you owe? What are the interest rates? When are the minimum payments due? A major part of managing your debt properly is fully understanding the debt you have. 

Take some time to make a list of all your debts including the name of the creditor, type (ie: credit card), the total amount owing, your minimum monthly payment, payment date, interest rate, and term length (if applicable). It might even be helpful to add if it’s a good debt or a bad debt. Put the numbers in a simple spreadsheet so it’s all in one place and you can keep track of it.  

Pro Tip: Pull a credit report for yourself online, it will come in handy to confirm your debt amounts and also helps to make sure you aren’t forgetting anything.  

Once it’s all in one place and staring back at you it can feel overwhelming, but that’s okay, this is the first step to managing your debt. Did you know that Canadians are 200% more likely to stay ahead on their debt payments when they track their expenses? That’s the power of debt (and money) management.  

Now what? You make a plan and put it into place. If you struggle with remembering to make payments, or if you don’t want to worry about it, you can start by setting up automatic payments so that you don’t fall behind. Then decide what debt you want to tackle first.  

The fact is, there are no shortcuts when it comes to getting out of debt, but there are some “quick wins” and best practices you can follow:

  1. Pay off debt with your savings. Yes, saving for emergencies is important, but so is paying off debt that’s costing you a lot of money. Credit cards are a good example of a debt you’ll want to have paid off, just be diligent about not overspending on that card again. 
  1. Take care of your high interest rate debt first. If you prioritize the highest interest debt first, then you’re saving yourself money in the long run. You can take that saved interest and put it towards paying off other debt, setting yourself up to pay off your debt faster. Remember that typically speaking, high interest debt is also bad debt. 
  1. Switch to a less expensive credit card with better cashback. This would ideally be a card that offers no annual or monthly fees. Even better if they offer high cashback at your favourite stores. We recommend the Neo Card, but we’re a little biased, so feel free to see if it’s right for you.
  1. Pay off high interest debt with low interest debt. Moving money around from a higher interest debt to a lower interest debt is a good idea to help put yourself in a better position. An example of this is paying off a credit card with a line of credit. But beware, this only works if you don’t rack up the charges on your credit card again. 

It’s possible that you’ve started looking at this a bit too late, or your life circumstances have changed and you find you can’t keep up with payments anymore. You can still manage your debt, it just looks a bit different:

  1. Get in touch with your creditors: if you’re unable to make your monthly payments, make sure to communicate with your creditor. This is not the time to put your head in the sand and hope for the best, it’s the time to get in front of it. Call your creditor and see what your options are. In most cases, you can sort out a payment schedule while you’re struggling. Not only will this help you manage your debt, it will help keep your credit score intact, and most importantly, it will reduce your stress and anxiety levels. 
  1. Talk to a credit counselling agency: if you're having trouble handling your debt or feel like you might be headed for bankruptcy, you may want to speak with a credit counsellor. Credit counsellors provide one-on-one services and work with you to figure out your best options. They can also help you negotiate payment plans with creditors. 

Another important strategy (other than the quick wins and best practices) is budgeting. Knowing how much money you can put towards debt on a monthly basis helps you put that debt management plan to work. 

Debt repayment strategies: snowball or avalanche?  

Regardless of the debt type, there are two main methods for paying it down. The snowball method and the avalanche method:

  • The snowball method: instead of focusing on what the interest rates are for your debt management strategy, this method works by paying off the smallest debt first, and working your way up from there. There is some basic psychology behind this method that many find effective. Quick wins are not only satisfying, but give you motivation and belief that you can pay off your debts. 
  • The avalanche method: with this strategy, you’ll organize your debts according to which have the highest interest rates, instead of the total dollar amount. You’ll pay off the balance on the loans with the highest interest first, while continuing to make the minimum payments on your other loans. This is a most cost effective way to manage your debt if you hold a lot of high-interest debt. 

The importance of making a proper budget

Canadians are 2x more likely to pay off their debt if they budget, which is why budgeting has made its way into this debt management conversation. There’s an aspect of leveraging a budget to pay off debt, but we can’t overstate the importance budgeting has in keeping you out of bad debt in the first place, or limiting the amount you take on. The truth is, approximately 30% of Canadians borrow to pay for their day-to-day expenses, this is one reason why credit card debt is so high. 

Budgeting: the basics and where to get started

Budgeting is all about balancing your income with your expenses, and understanding where your money is currently going is the first step. Once you know that, you can understand your spending habits, and decide if they match your priorities. 

Spending $1,000 per month eating out? It might make more sense to put most of that towards paying off debt, saving for a down payment, or putting money away for retirement. . 

The good news is that we live in a digital world. This means you don’t have to track your spending for the next month to see where your money goes, you can actually pull your statements for the past 3 months and see what your averages are, which means you can get started today.  

Before pulling your statements, make sure you go into this process without judgment. You want to have a true and realistic view of what you have been spending. Right now you’re only categorizing your spend, not judging it. 

Creating a budget: best practices and getting insight

Earlier we recommended using a basic spreadsheet for listing your debts, the same is true for budgeting. You can absolutely use budgeting tools and software that exist, but for keeping it simple you really only need a spreadsheet. You can worry about tracking your every expense later, right now you just need insight into your spending habits to put a plan in place. 

Categorization

Once you have your statements, you’ll want to take each expense in the past 1 to 3 months and categorize them. This organization helps you see what buckets you spend the most in.

Here are some category suggestions:

Income vs. expenses

To calculate overspending, you’re going to want to grab your take-home income (the exact amount you get paid after taxes) and add that to your spreadsheet. Next, add up all of your categorized expenses then take your income and subtract your expense total. This is where you see if you're overspending, or if you have room in your budget. 

If the number is negative, then you are spending more than you make each month, this would most likely explain why you’re in debt. If you make more money than you spend, then you’re ahead of the game and can start putting that income towards your debt management plan. 

Budgeting

Once you have finished compiling all of your finances, you should have a clear visual representation of your financial situation, this is where budgeting begins. Knowing what you spend versus what you earn helps you to determine where you should focus your efforts and attempt to reduce costs. 

Go back to your debt management plan: what debt did you decide you wanted to tackle first knowing your cashflow? How fast can you pay it off? Where can you cut some spending to pay it off faster? It’s true you might have to change that vanilla latte to an occasional treat instead of a daily habit, but there’s a payoff that will be so much sweeter.

When you are going through the numbers, ask yourself some questions: what are my financial goals and priorities? Are there big differences between my spending and earnings? If so, what categories do I overspend on? Are these discrepancies due to unique, one-time situations, or can I expect these to continue? Am I going to be able to save enough money to reach my financial goals? What are my needs vs. my wants? 

Once you’ve decided your priorities and established a budget in each category, you officially have a budget, now you can actually start budgeting. This is where budgeting software comes in handy. A lot of them allow you to link your accounts directly to the app, where it takes your expenses and categorizes them for you, letting you track your spending to your budget in real-time.  

Remember if your financial situation changes, say you get a raise, make sure to re-evaluate your budget and adjust accordingly. 

The average Canadian spends $4.68 per coffee. A coffee a day comes to $1,708.20 per year, that’s over 1 month of rent. 

Saving or debt repayment: which is better?

Is it better to save or pay off debt? If you have lots of debt and little to no savings, what is the best course of action? Should you try to put away a little money, or begin to put a dent in that debt?

The long and short of it? Your best course of action depends on your specific situation. Ideally, your strategy will enable you to work toward your debt management goals while also tucking some money away for a rainy day, and your future. 

If you’re limited on assets, feeling pinched to make payments, and debt stresses you out, then a good rule of thumb is to pay off your bad debt first before building savings, or at least your credit cards. Bad debt with high interest rates costs you on a monthly basis, and by starting to pay off this debt you can take the interest saved and put it away for yourself. 

Another school of thought is, “pay yourself first.” This is sound advice if you’re holding good debt, have limited or no bad debt, and are putting money away to secure your financial future.   

In either case, it’s a good idea to work towards building up your emergency fund to keep you out of having to take on bad debt should something come up. The best scenario would be for you to have 3 to 6 months of income set aside. We know that this isn’t possible in some situations, but keep it in mind as a marker for the future.

Once you have picked the approach that fits your unique situation, you can begin to take action. It’s also helpful to put leftover money from groceries or vacations toward your debt. The same goes for workplace bonuses, tax returns, and gifts on special occasions (holidays or birthdays). 

Pro Tip: Rather than keeping all of your funds in a chequing account, a no-fee high interest savings account is a great way to keep your money growing.

What is TDSR? Understanding Total Debt Service Ratio

Since we touched on mortgages, it's a good time to explore a term that is frequently used in the banking industry: Total Debt Service Ration or TDSR.  

TDSR is a metric that helps lenders know if you’ve taken on too much debt, or if you have room to take on more. TDSR is a percentage that is calculated by taking your total debt obligation (ie: monthly debt payments) divided by gross income. In other words, how much you owe versus how much you make. 

A mortgage is the most common and significant type of debt held by Canadians.

This is the most common way mortgage lenders assess your creditworthiness. Your TDSR is made up of two parts, the housing factor, and non-housing factor. The housing factor is everything paid for your home, including your mortgage payment, property taxes, utilities, homeowners insurance, etc. The second part includes everything else, such as auto and student loans, child support, and credit card debt.

Let’s break it down into points to make it easier to understand:

  • Your TDSR is the metric used by mortgage lenders to determine a potential borrower's ability to take on a loan.
  • The TDSR includes both housing expenses as well as non-housing expenses. 
  • A TDSR below 40% is usually the benchmark to obtain a mortgage.

When you apply for a mortgage or loan, you should be aware that your TDSR is a major factor in determining if you qualify for a mortgage or not. But don’t forget that  a stable income, timely payment of bills, and a good credit score are just as important. 

Simplifying debt: how does debt consolidation work exactly?

Debt consolidation is something that should not be overlooked and is important for everyone to understand. Debt consolidation is a way for you to manage your debt, pay less interest, reduce your monthly payments, and work your way out of debt (especially bad debt). 

The idea of debt consolidation is to take your debt (typically bad debt), and get a loan to pay off and close the debt you are consolidating. This enables you to organize your monthly payments, have a fixed term for when it will be paid off, and pay less interest overall. Then you will just be paying a single monthly payment on your new loan.  

Debt consolidation will only work if you avoid getting more bad debt, otherwise you’ll end up in the same (or even worse) situation than before. 

You can also get a line of credit to consolidate debt, but it’s revolving and has no end date, which means it takes all of your debt and puts it in one place, but doesn’t put a plan into action to force you to pay off your debt during a set amount of time. We only recommend this method if you’re diligent with your money. 

Balance: striking the right balance for your situation

With knowledge, a debt management plan, budgeting, and some discipline, you can change your financial circumstances and set yourself up for success. The most difficult part is getting started and committing to new habits. 

As you’ve found out, there are no hard and fast rules that apply to everyone. The key is finding a balance that works for you, making a plan, and sticking with it. That’s why a good debt management plan is a combination of methods you can use to pay off your outstanding debts and start saving. 

75% of Canadians worry about their finances. Let’s start lowering that number and be empowered to make good financial choices. The benefits are monetary, but there’s so much peace to be found by putting your financial troubles in the rearview mirror.

This article provides information and is not intended to provide any personalized tax, investment, financial, or legal advice. You are encouraged to seek professional advice before making financial decisions.

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