Debt 101: understanding the basics

In simple terms, debt is when you owe money. It can come from purchases you place on your credit card, like groceries, electronics or entertainment. It can also come from larger purchases, like replacing your roof, paying school tuition or buying a home. Certain types of debt can help improve your long-term financial situation, but sometimes too much debt piles up and can become a burden. Let’s explore the different types of debt.

Good debt habits can help you build on your current and future financial situation. For example, student loans for post-secondary education can help your future income prospects by giving you the skills to take on higher-paying jobs in your field. Mortgages are another example, because the value of a property typically increases over time while you are paying down the debt, with the overall goal of building equity in your home.

Bad debt habits, on the other hand, put a strain on your cash flow and can hold back your ability to invest in your future with extra funds. Loans for vehicle purchases are one example, because the purchased vehicle decreases in value over time. Other examples include overspending on consumer goods like clothing, food and entertainment that are purchased on credit cards. When excess credit-card debt builds up, it can become difficult to manage and a challenge to pay off, and will add interest costs.

A great place to start is by thinking about the amount of debt you owe compared to the amount of income you earn. This is referred to as the debt-to-income ratio. Divide your total monthly debt payments by your total monthly income. Then, multiply the resulting decimal by 100 to turn it into a percentage. 

Debt-to-income ratio = total monthly debt payments ÷ total monthly income

For example: $1,500 of monthly debt payments ÷ $3,500 in total monthly income × 100 = 43% debt-to-income ratio

This percentage represents your debt-to-income ratio and it can help you understand how much of your money is going towards funding your overall debt. A higher percentage may mean you have too much debt for the amount of income you earn. A good balance to aim for is about 35% or less.

The following signs may also indicate you have more debt than your income can support:

• Your debt-to-income ratio is 50% or more
• You often make late payments 
• You only make minimum payments on your credit cards
• You’ve maxed out your credit cards 
• You’ve been rejected for new lines of credit
• You don’t have an emergency fund
• Your bank account is at or below $0

If debt is a challenge, it doesn’t always mean a dead end. It could be an opportunity to reorganize and rethink your finances by revisiting your cash flow, identify areas to save money and optimize savings strategies.