“Live within your income, even if you have to borrow money to do so.” – Josh Billings
The idea of being in debt is disturbing to many people, but without it, most of us wouldn’t be able to purchase a new home or a new car. It is often more convenient and safer to use credit cards than cash. However, once you go into debt, your main concern should be minimizing the cost of borrowing.
Debt management is simply how well you handle the debt you have now and how prepared you are to handle debt in the future. Effective debt management is critical to a sound financial plan. Reducing debt often ranks as a primary financial goal.
Types of Credit (Debt)
Credit cards and lines of credit provide ongoing credit that you can use as you need it, while loans and mortgages are for a specific purpose with a set repayment schedule. The following is a primer on these types of credit.
Credit Cards – Credit cards are issued by financial institutions and retailers. In exchange for the credit privilege, you agree to pay an interest charge on the outstanding balance each month. You may also have to pay a service fee. You can increase your limit as you develop a credit history.
Line of Credit – Financial institutions offer qualified customers a personal line of credit as a convenient substitute for personal loans. Funds are available whenever you need them up to a set limit. They can be secured (Home Equity secured for example) or unsecured. You pay interest only on what you use. Lines of credit can be cheaper than a cash advance on a credit card or an overdraft on your chequing account.
Consumer Loans – Consumer loans are usually arranged for a specific amount and a specific purpose, for example $15,000 for a new car payable over four years. You repay the loan in fixed monthly payments that are a blend of principal and interest. The interest rate may be fixed for the duration of the loan or may be variable.
Mortgage – A mortgage is a loan used primarily to pay for the purchase of a residential home. The property being purchased becomes security for the loan. You generally must make a down payment towards the total purchase price. The remaining amount is then financed through the home loan. Again, the interest rate may be fixed or variable for the term, and the payments are a blend of principal and interest.
The Four C’s
When you apply for credit the lender will assess you on the “Four C’s”
- Capacity: Your ability to repay debt based on your income and financial situation.
- Character: Judged by the relationship you have with your financial institution. It includes the level of trust and credibility you have established.
- Credit History: Your credit rating, which is based on past debt repayment and your financial situation.
- Collateral: Property or assets that can be used to secure the loan. In the event of default, collateral could be sold to pay the loan.
How Much Debt Is Too Much?
Everyone has their own comfort level with debt. For some, any debt is too much. For others, debt is a way of life. The financial planning industry uses an objective measure as a guideline – the debt/equity ratio:
Total Debt – Mortgage on Principal Residence
Total Net Worth (Total Assets – Total Liabilities)
Your debt/equity ratio should be less than 0.5, or 50%. This does not mean you will automatically qualify for a loan. It simply measures how much debt you are carrying.
Danger Signs of Debt
- You spend more than 25% of your take-home pay to service debts (excluding your mortgage).
- You defer paying regular bills.
- You carry credit card balances and pay only the minimum amount.
- You borrow money to make loan payments.
- You’ve lost track of how much you owe.
- You have no cash to meet emergencies.
How well do you handle debt?