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Understanding debt

From: Financial Consumer Agency of Canada

Basics of debt

Debt is money you owe to creditors.

For example, you may owe money to:

You need to pay back your debts.

If you don’t pay back your debts, you may face negative consequences, for example:

Learn how to pay back your debt.

Fees and interest

Lenders, like financial institutions, usually charge fees for borrowing money. The amount you borrow is the principal. Your debt includes the principal and fees.

Examples of these fees include:

Non-lenders may charge various fees for their products and services. For example, your internet provider may charge set-up fees and other administration fees.

Consider all the fees when you get a product or service. These may add to your total debt.

Find out what you need to know before you sign any contract.

Past due accounts

If you don’t pay your bills on time, you’ll usually need to pay additional fees. This will increase your debt.

Examples of additional fees include:

Make sure you understand the terms and conditions before agreeing to any product or service.

Types of Debts

There are different types of debts. There are secured or unsecured debts, and good or bad debts.

Choosing between these types of debts is important for your financial wellbeing. Make sure you understand the differences and choose the best options for your needs.

Learn about choosing financial products and services that are right for you.

Secured and unsecured debts

You may have secured and unsecured debts.

Secured debts

Secured debts are products backed by collateral. Examples include car loans, mortgages, home equity lines of credit and secured credit cards. Collateral may be anything valuable, like a house, a car or a security deposit. For example, with a mortgage, the house itself is the collateral.

If you default, the lender may take the collateral to recover their losses. Defaulting typically means failing to make multiple payments over an extended period.

Because they may take your collateral, secured debts are less risky than unsecured debts for lenders. As a result, they typically charge lower interest rates on secured products.

Unsecured debts

Unsecured debts aren’t backed by collateral. Examples include personal loans, credit cards and utility bills. Creditors usually approve them based on your credit history.

If you default, creditors can’t take your assets. They may take legal action or use their right of offset. The right of offset allows some creditors to take money from your bank account to recover what you owe them.

Learn more about the right of offset.

Unsecured debts are riskier for creditors compared to secured debts. As a result, creditors typically charge higher interest rates on unsecured products.

Good and bad debt

A debt may be good or bad.

Good debt

A good debt helps you achieve important goals. It increases your net worth, generates income and improves your financial future. Examples of good debt include student loans and mortgages.

Bad debt

A bad debt is when you borrow money for non-essential items or things that lose value. It often has high interest rates and may cause you financial problems if you manage it poorly. It may negatively impact your finances and make it hard to save money. Examples include credit card debt, payday loans and personal loans for unnecessary things.

Impacts of debt on your future

Debt may have several long-term effects on your future, impacting various aspects of your life.

Financial strain

When you have debts, you need to allocate part of your income to repayment. This may limit your ability to save or invest for the future. You’ll continue to pay interest, which may significantly increase the total amount you owe.

You may end up getting stuck in a debt cycle. This means you’ll need to continuously borrow money to pay off debts. It leads to accumulating more debt over time. This happens when you take out new loans or use credit cards for expenses you can’t pay off.

Breaking free from debt involves:

Learn how to reduce your expenses.

It may be helpful to seek financial advice or use debt consolidation strategies.

Learn how to get help from a financial professional.

Limited financial freedom

Poor management of your debts may have a negative impact on your credit report and credit score.

Examples of factors that may negatively impact your credit score include:

Companies may use this information to help them make decisions about you.

These include, for example:

Some employers check your credit report and score for job offers or promotions.

Learn more about credit reports and scores.

Mortgage qualification

When you apply for a mortgage, lenders evaluate your:

The GDS ratio measures the percentage of your gross income that goes towards housing-related expenses. These include mortgage payments, property taxes, heating costs and condo fees.

The TDS ratio includes all your debts. These include your housing costs plus other debts like car loans, personal loans and credit card payments.

These ratios help lenders to determine how much additional debt you may handle without risking default. If your ratios are within acceptable limits, a lender is more likely to approve your mortgage. If your ratios are too high, you may not qualify for a mortgage.

Learn more about the GDS and TDS ratios when preparing to get a mortgage.

Health impacts

Stress related to debt may have a negative impact on your physical and mental health.

Health Canada encourages Canadians to take a more active role in their health.

Learn more about mental health and wellness.

Causes of debt

Debt may happen for many reasons. Understanding the causes of debt may help you take proactive steps to manage and reduce your debt.

Learn how to limit future debt.

Poor money management

Without a budget or plan, you might overspend, rely on credit and miss payments. Missing payments may result in additional costs, adding to your debt.

Making a budget helps you track your income and expenses to make sure you’re living within your means.

Learn how to make a budget.

Prioritize the repayment of your debts to help you avoid unnecessary spending.

Learn how to choose a debt repayment strategy.

If you’re unsure about your financial decisions, consider consulting a financial advisor or credit counsellor. They may provide you with personalized guidance and help you develop a financial plan.

Learn how to choose a financial advisor.

Learn how to get help from a credit counsellor.

Unexpected expenses

If you face unexpected expenses that you can’t afford, your debts will increase.

Examples include:

You may reduce the financial impacts of unexpected expenses by setting up an emergency fund. An emergency fund is money you set aside to pay for unexpected expenses.

Learn how to set up an emergency fund.

Employment and income

You may have difficulties paying your monthly expenses due to insufficient income. This may be because you lost your job, have a low paying job or are underemployed.

If your monthly expenses are higher than your income, you’ll accumulate debt.

Learn how to increase your income and reduce your expenses.

Learn more about what you may do if you lose your job.

Life events

Personal life changes may significantly impact your financial situation. These changes often require careful financial planning to manage the increased expenses and avoid accumulating excessive debt.

Make sure you prepare and adjust your budget accordingly.

Examples of personal life changes that may impact your finances include:

Education

Pursuing higher education may lead to significant debt. Tuition and living expenses add up quickly. Your opportunities to generate income while studying may be limited.

Many students rely on loans, which accumulate interest and increase the total repayment amount. After graduation, underemployment and low starting salaries may make repayment difficult.

Learn how to manage your budget as a student.

Use scholarships and grants to help pay for education. Take advantage of tax deductions and tax credits whenever you can.

Learn more about student aid and education planning.

Home ownership

Becoming a homeowner may be exciting, but it’s not always the best decision for everyone. Consider all costs before buying a home.

Learn more about buying a home.

Children

Childcare, education, and extracurricular activities may quickly add up. Daily necessities like diapers, clothing, and food may impact your finances.

Learn about family and caregiving benefits.

Death

The death of someone close may have financial implications that may increase your debt. Costs may include funeral and burial expenses, estate and legal fees, and loss of financial support.

These financial challenges may be overwhelming, especially during an already difficult time.

Learn what to do when someone dies.

Divorce or separation

Legal fees and the division of assets may be financially draining. You might need to pay child support, which will add to your monthly expenses.

Maintaining 2 households is more expensive than 1. You’ll need to pay your mortgage or rent, utilities, and other living expenses separately.

Learn more about legal matters when living as a couple.

Marriage

A wedding may be 1 of the biggest expenses for a couple. You’ll need to decide together how much you’re comfortable spending.

Consider all the costs and make sure you can afford them.

Learn more about the costs of getting married.

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