There is a cause-and-effect relationship between rising inflation and consumer debt. The rising cost of living has raised concerns amongst Canadians, thus, leading them to increase their debt to cover expenses.
In such situations, it becomes extremely important to understand what debt is and how can it be reduced. Debts can either be good or bad depending on a person's future financial outlook.
For instance, if it’s an education loan or mortgage, the value will appreciate over time and hence, this is good debt, as it improves future finances whereas bad debts are the ones that have no long-term value, such as credit cards or personal loans.
Nearly one-third of Canadians find it harder to pay down their debts according to the latest consumer debt index. Post-pandemic, people are generally more focused on keeping their financial habits in check. So, what are the different kinds of debt?
Today’s edition of "Finance from A to Z" is about this very crucial ‘D’ of finance, in more ways than one.
D is for Debt(s):
Debts appear when one borrows money and agrees to repay it. We are aware of debts such as student loans, credit card purchases, or mortgages but let’s classify these debts so that we know how these categories can influence our financial decisions.
There are, in general, four types of debts: Secured, Unsecured, Revolving, and Installment debt.
- Secured debts come with lower risk as assets always back them up. Lenders consider if debts can be repaid. So, in this case, a secured credit card would be the one where cash is deposited before it is purchased. Lower risk favours better financing and comes with lower rates.
- Unsecured debts are not backed by any assets. Student loans and traditional credit cards fall under this category. Lenders qualify borrowers based on credit scores, payment history, and outstanding debt.
- Revolving debts are such things as personal lines of credit and home equity lines. A credit card has a credit limit that is set by the lender. Qualifying for revolving debt means the minimum payment for credit may change each month. Revolving debts are open-ended.
- Installment debts are unlike revolving debts. They are closed-ended. They can be secured or unsecured debt. "Buy now and pay later" is one such type of debt that falls in this category.
D is for Debt Management:
Now that we have discussed the different types of debt, let’s talk about how one can manage their debt. You can either do this yourself or you can work on managing your debts with a credit card counsellor. By evaluating your financial situation and taking a quick glance at your financial goals, you can, yourself or with help, create a specific budget for yourself.
There are various ways to keep your debt in check. Some of them include:
- Creating a monthly bill payment calendar for yourself so that you don’t miss payments.
- Avoiding late payments for credit cards, in case you don’t have enough to pay in full, make at least the minimum payment for the credit card.
- Prioritizing which debt to pay off and finishing off with the small ones. It boosts confidence and ticks off debt from the list.
Now, another question that often comes to our mind is whether we save first or pay down our debts. Can we do both at the same time?
Our best-case scenario will always be a life where we are debt-free and at the same time, we have money saved for emergencies when needed. Keeping that in mind, our pro-tip would be to always create an emergency fund that should cover six months of expenses, ideally. If not, aim for three months-worth of money saved away. Also, open a high-interest savings account that continues to grow and can be eventually used to pay down debts.
Our next focus is debt repayment. There are two ways that you can consider this: one is to pay off small debts and eventually work on expensive things. The other strategy is to rank your loans based on interest rates, then focus on paying off the ones with higher interest rates first, while paying a minimum amount for other loans.
The key here is to always find a balance between saving money and paying off debts. Prioritize significant debts, build on savings, and keep your finances in check.
Please share your thoughts in the comments below on how you manage debt.
I would love to know your thoughts.
Thanks and see you in the next week!