Recently we have been inundated with news articles about Canadian household debt. While there was a reported decrease in household debt last year, according to Statistics Canada, “the ratio of household credit market debt to net worth increased to 24%” this year. Granted, some of this debt is what is considered “good debt,” but some of it is what is referred to as “bad debt.”
Good debt, bad debt
Believe it or not, not all debt is created equal. Some debt is even considered good to have. Typically, debt used to purchase things that will increase in value is considered “good debt”. Stocks and houses are considered good debt. Generally, interest rates on these types of debts are lower. The interest you pay on money that is borrowed for investment purposes can be tax-deductible, as well, making overall interest rates even lower.
Student loans are also considered good debt since, for the most part, university graduates make more money in the long run. Interest rates on student loans are fairly low and tax-deductible as well.
Some financial advisors also consider borrowing money to invest in RRSPs a good debt, but only if it’s paid off within a year.
While good debt can help you get ahead, bad debt has a nasty habit of getting out of hand quickly and burdening the borrower. Bad debt includes money borrowed to purchase anything that will depreciate in value, including cars, clothing and merchandise, such as computers and flat-screen TVs. Bad debt is never tax deductible and won’t help you make more money in the long run.
As well, it’s important to note that all of these good debt examples make certain assumptions that wont necessarily pan out 100 percent of the time. Your stocks wont always go up, the value of your home isn’t guaranteed to increase and you may not get a great paying job fresh out of university or college (or even years post grad for that matter). It doesn’t take much for good debt to turn into bad debt.
In order to curb debt, financial advisors recommend that consumers learn to distinguish between needs and wants. To reduce impulse buys, ask yourself whether you really need to make the purchase, especially if it’s on credit. Ask your credit lenders not to raise your credit limits without your permission. Don’t borrow every dollar that your mortgage lender offers you. Think about whether or not you really need that line of credit. Consider the possibility that interest rates will rise in the future. Will you be able to handle them if and when they do?
More on this later in the week…
How much is too much?
On average, Canadians report $25,597 is credit card and retail debt – up 4.5 % from last year – and many of them make only the minimum monthly payment. Experts agree that if you are having trouble making the minimum monthly payment on your debts, you’re in trouble. Creditors, who are in the business to make money, don’t care about your financial woes. They’ll increase your rates and offer you more credit if you need it. It’s your responsibility to make sure you can make the payments. So how much debt is too much?
Lenders divide your debt into two debt ratios: Gross Debt Service Ratio (GDS) and Total Debt Service Ratio (TDS). GDS is the sum total of your monthly housing expenses, divided by your gross monthly income. Lenders agree that your GDS should not exceed 32% of your income. GDS includes the following:
- Monthly mortgage payment
- Heating costs
- Real estate taxes
- Home insurance
- Association dues or condo fees
Total Debt Service, or TDS, is the sum total of your monthly housing expenses plus your other monthly debt payments. Financial advisors agree that your TDS number should not exceed 40% of your income. TDS expenses include:
- Car payments
- Credit cards payments (lenders typically assume 3% of your total outstanding balance)
- Personal lines of credit
- Personal loans
- Student loans
Surveys show that the number one financial goal of most Canadians is to pay down their debt. While some will stick to this plan, others will fail. Borrowing to the max can leave you with little room to move, especially if interest rates rise, as they are expected to. If you feel your debt is out of whack, put a plan together to get it under control. Later this week, we will be posting another article with tips for managing your debt. Until then, spend wisely!
Melanie
Writer for RateSupermarket.ca
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