Our debts have been growing over the years. According to the Bank of Canada, household debt has risen for 30 years and in 2017 we reached just over $2 trillion in collective debt. High levels debt puts debt holders, and our economy, in a vulnerable position. Think of an unforeseen negative event happening, such as job loss or a recession.
If your debts are becoming unmanageable and overwhelming, you might be feeling vulnerable and stressed out. Are you looking for a way to get out of debt? We’ll give you a comprehensive guide to how you can cut down your debt load, choosing which debt to pay off first, and maybe turn that debt boulder into a pebble.
What is bad debt vs good debt?
The term “good debt,” as opposed to bad debt, sounds like an oxymoron. How can any debt be good for you? Debts like student loans, mortgages or car loans are considered positive debt because they are a form of installment credit, meaning you usually service the debt at the exact same amount for the duration of the loan. Plus, the loan is negotiated with consideration of how much you can afford at the time of issuance.
Installment credit is considered positive also because it often comes with a low interest rate. Plus, it helps your credit score when you responsibly pay it all back over the debt’s duration.
Student loans, though they feel like a ball and chain, are the best kind of debt because they provide a tax break at the end of the year. No other debt provides a tax benefit.
If debt is so great, then why are you feeling so stressed?
It’s usually because of negative debt, otherwise known as revolving credit. This is exactly what you think it is – credit cards and other lines of credit. Revolving credit typically commands the highest interest rate and can escalate quickly when you miss payments or spend beyond your means.
What debt should you pay off first?
Our good debt vs. bad debt comparison isn’t necessarily a guide to which debt you should tackle first. There are varying views on debt repayment strategy and what your priorities should be.
According to some, debts should be categorized into three columns in order of importance – debts with high interest rates, accounts with high credit utilization, and accounts with the smallest balance.
Debts with high interest are revolving credit, like credit cards with rates anywhere between 20% and 30%. These are the hardest to get a handle on because you’re spending so much servicing the interest, which is why most agree this should be your first target for getting out of debt fast.
Accounts with high utilization can also mean credit cards or lines of credit with high limits. The objective here is to prioritize a healthy credit score and that’s achieved by lowering your balance and creating available credit. This will set you up for the future, when you’ll need a decent credit score to get approved for, you guessed it, more credit! If you plan on buying real estate or a car, you need a decent credit rating.
It’s recommended your credit score utilization should be less than 30%. For example, try not to owe more than $3,000 on a $10,000 credit limit.
Your smallest debts – the ones with the lowest balance – might seem the least urgent to pay off, but there are different schools of thought on that. The psychological aspect of accomplishment can’t be overstated. By throwing the most money at the smallest debt, you will see immediate progress, as you conquer that debt much sooner than you would the others. That feeling of accomplishment will motivate you to go after other debts with the same conviction.
So not only are you gaining momentum in getting out of debt, you are freeing up cash to put towards those other, more daunting debts. Knocking off a $3,000 debt before going after a $10,000 will give you a quick win and encourage you to keep going after the remaining debt burdens.
How to slice down credit card debt – the snowball method
As more and more of our daily lives migrate online, so does the way we pay for goods and services. Credit cards are more important than ever before. We use them for convenience, rewards and to build up our credit scores. Unfortunately, there’s a downside – we’re racking up debt! The average Canadian owed $2,627 in credit card debt according to a study in 2017.
So, should take a pair of scissors to that VISA or AMEX? Some say yes – it’s the only way to get serious about eliminating that boating credit card balance. You can always get a new one once you’ve cleared that high-interest debt.
A less drastic approach is a debt reduction strategy called the “snowball method” and it can be used for all your debts, not just plastic. It derives its name from the idea of rolling snowballs in order to create bigger snowballs. Kind of like you did when you were a kid making a snowman.
The system works like this – you pay off your smallest debt first and go from there. For example, if you have multiple credit cards, pay off the smallest balance first regardless of the interest rate. Of course, you need to still make monthly payments on those other cards, but heap everything you can on that small balance first to get it cleared. Once you’ve paid it off, you “roll” the extra funds you were paying on that previous debt into the next smallest balance. Repeat until each debt is paid in full.
As mentioned earlier, a major benefit of this method is the mental reward that comes with eliminating debt. It will give you the momentum needed to tackle other debts and get out of debt faster. The method is not exclusive for credit cards; use it for all your debts.
Is debt consolidation an option?
Debt consolidation might be a good option, in the right circumstance.
If you’re juggling debts and feeling overwhelmed by all the many debt tentacles pinching money out of your income, a debt consolidation loan could be your harpoon to spear that debt beast.
Debt consolidation is when you shuffle all your debts – credit card, lines of credit, student loans, etc. – into one behemoth debt that allows you to make single payments on, as well as have a lower interest rate than the various debts you’re consolidating. This solution is appealing because it makes debt repayment more manageable.
However, consolidation is only available to those with healthy credit ratings since you’re essentially asking a financial institution to give you a big loan. Sounds strange to take on more debt to battle debt but consider the interest on the loan (12%) versus what you’re paying on those credit cards (20-30%).
How debt impacts your credit score
Credit scores are not something most of us actively think about, but its importance can’t be ignored. Healthy credit ratings make it easier to obtain loans like a mortgage, convince a landlord you are not a risky tenant, or start a business, just to name a few.
National agencies like Equifax Canada and TransUnion Canada gather credit information on us and produce a three-digit number to determine, essentially, how reliable we are as borrowers. Our credit scores are determined by debt payment history, outstanding debts, credit history and recent inquiries. If you default on a loan payment, for example, that’s going to negatively affect your credit score. Lower balances (higher credit utilization room) and prompt debt repayments are key ingredients to maintaining or improving your credit score.
Don’t lose your smile over debt
Nobody (sane) has ever called paying off debt a fun endeavour. Frankly, it’s a dreary, thankless task which can take much time and patience. So while it’s important to tighten that proverbial belt and get a grip on your ever-consuming debts, don’t forget to still indulge once and awhile on things that bring you true value in life. Don’t remove everything fun all at once and try to go cold turkey. Ease into it and enjoy those rare indulgences – you earned them.
Fresh Start Finance serves Canadians facing all types of credit situations with practical advice and credit-building solutions. We also offer quick-and-easy secured and unsecured installment loans to help you take those first steps to a better financial future. Apply today to see how we can help!