Debt is like a tool. It can be good or bad, depending on how you use it. Good debt can improve your financial position, while bad debt can hurt your finances. Before you borrow more money, understanding how debt can help or hurt you is crucial. Answering the right debt questions will help you decide whether taking on more debt is wise.
Understanding Debt: The Key to Financial Empowerment
The type of debt you have could be good or bad. Good debt gives you the opportunity to enhance your financial position. Some examples are a mortgage that allows you to buy a home, borrowing to invest, or student loans that give you the opportunity to upgrade your education so you can potentially earn more money.
Another way debt can benefit your finances is to use it as forced savings. If you have the cash for your purchase but are earning a higher investment rate on it than the interest you’d pay on the debt, it might make financial sense to borrow.
Borrowing lets you keep your money and make payments. That way, once your debt is paid off, you’ll have your savings and the item you bought.
Bad debt however, is money you borrow to pay for things that have little or no lasting value. Examples of bad debt include:
- Buying an expensive car that depreciates.
- Using your credit card to pay for consumer purchases.
- Carrying a balance on your credit cards.
You’ll have to make payments at high interest rates on these types of items and will have little, if anything, to show for the money you spent. This unfortunately, is the debt trap that many people fall into.
It’s easy to add to your debt load if you have access to credit. Life gets busy and sometimes we borrow in the moment without thinking about how it will affect us later on. Asking yourself the following debt questions before you pull out your credit card or sign for a loan can help you manage your debt to benefit you.
Do I need it? – The Want vs Need scenario
The availability of credit makes it simple to buy things we don’t need or can’t afford. If you must borrow to buy something, ask yourself if it’s necessary. Some situations may be unavoidable, such as needing a new furnace or expensive repairs on your car. However, if you don’t need the item or service immediately, consider alternatives to reduce or eliminate the amount you need to borrow.
If your need isn’t urgent, some options are:
- Waiting for the item to go on sale.
- Comparison shopping to get the best price.
- Buying it second-hand.
- Saving your money so you can pay cash.
- Renting instead of buying.
- Finding a cheaper alternative.
You may have an urgent need that makes waiting impossible. If you’re in this situation, there are ways to minimize your borrowing costs to make sure you don’t put your finances in jeopardy.
How much can I afford to borrow?
Having a manageable payment is key to reducing financial stress. Your payment is made up of the amount you borrowed (principal), your interest rate, and the length of time it will take to pay off the loan (amortization). Mortgages, personal loans, and car loans are amortized, and you’ll have a payment plan that includes principal and interest.
Other types of debt, like credit cards and lines of credit, don’t have an amortization period. Instead, you make a minimum payment of principal and interest. If you only make minimum payments, you may never pay off a credit card or line of credit.
Prepare a budget
You can calculate the affordability of any new debt you’re considering by taking a few steps. First, make a monthly budget plan. Determine how much income you have coming in, your living expenses, and how much you are paying for existing debt. Your budget will show you if you have enough room to take on an extra payment.
Use a debt calculator
A debt calculator is a handy tool that’ll help you figure out how much your payment will be. You need to know the amount you want to borrow, the interest rate, and the amortization. Once you input those values, the calculator will show you your payment. Using a debt calculator will help you decide if the payment fits with your budget or not.
Will I be approved for more debt?
You can use your available credit on a line of credit or credit card without having to apply for more credit. You may need to apply to borrow more if you don’t have access to available credit, and the lender must approve your request.
Before approving your credit request, the lender will look at your income, employment, credit history, total assets, and total debt. One important factor they consider is your debt ratio, which is the percentage of your pre-tax income that goes towards debt payments. Generally, your debt ratio can be at most 44% of your pre-tax income. If, for example, you make $4,000 per month before taxes and deductions, your debts (including rent or mortgage, property taxes and heat) cannot exceed $1760.00
If you have poor credit, unstable employment, or a debt ratio that will be too high with the new loan, your lender may decline your request for more money.
Do I have a backup plan?
A backup emergency plan is great for all situations, including taking on extra debt. Ask yourself how you’ll manage your payments if you lose your job or cannot work because of illness or injury. No one likes to think this way, but having a general idea of whether you can financially survive with a life change will help you in the long run.
Some mortgages, loans, credit cards, and lines of credit offer various types of insurance that can temporarily cover your payments. It’s usually up to you whether you want to purchase the insurance.
Another backup plan is having an emergency fund that can cover your debt payments for a few months.
Having cash on hand to help you with financial problems is also helpful. You can use savings to cover debt payments if necessary.
Getting Help With Debt
Life is expensive these days, and we are often taking on more debt to pay living costs or borrowing to make our existing payments. Debt relief is available, if you’re overwhelmed by the amount you owe.
Contact a Licensed Insolvency Trustee (LIT). A LIT will work with you to find the best solution to your debt. They’ll answer all your debt questions and offer credit counselling to help you manage your payments. If your debt is more than you can pay, they’ll negotiate with your creditors and help you file a Consumer Proposal or file for Bankruptcy.
Don’t take on more debt if you don’t need to. And if you’re struggling financially, help is just a phone call away. Our trusted Licensed Insolvency Trustees will work with you to find the right solution for your needs. Call us at 1-888-371-8900 or contact us online to book a free consultation. You’ll be surprised how quickly and easily we can help you get back on track. We Can Help.
