Lesson 3: Understanding Debt

Credit cards can also lead to overspending and debt if you're not careful. It's easy to get sucked into the trap of "buy now, pay later," especially when you're tempted by flashy rewards or enticing offers. The main issue with credit cards is the insanely high interest rate (often at least 14%!). Unfortunately, banks aren’t charities. They’re businesses that need to make money, so when you carry a balance on your credit card, the bank charges you interest on that balance because you owe them money and you’re not paying them back on time. Unfortunately, these interest rates are often sky-high.

If you don’t pay off your debt in full, you’ve agreed to pay them a little bit (the minimum), plus you’ll be charged a high fee (interest or APR). There are of course extreme circumstances where going into credit card debt may be your only option, but in most cases you should never purchase something with a credit card that you don’t think you can pay off in full by the time the bill is due at the end of the month. If you find yourself in a situation where you can only pay the minimum, it’s okay!

Many of us have been there! But it’s important to look at your budget and determine how you can adjust your current spending or increase your income to help pay this debt off quickly to avoid paying huge interest fees (we’ll talk more about paying off debt later on).

These compound interest charges add up very quickly, and make it harder and harder to pay off the money you owe. Why? Because now you’re getting charged interest on the money you borrowed (this is called the principle) AS WELL AS being charged interest on the interest charges you’ve already accumulated. Yikes.

What if you pay the monthly minimum? Well, it’s better than not paying anything (if you do that, the bank will add additional charges and eventually you’ll end up in a lawsuit). When you sign a contract to get a credit card, you’re agreeing that you’ll pay back any money you borrowed that month.

Mortgages

Ah, the cornerstone of homeownership! Mortgages make it possible for many people to buy a home without having to save up the full purchase price. With favourable interest rates and potential tax benefits, mortgages offer a path to building equity (ownership of the home) and stability.

However, they also come with long-term commitments and the risk of foreclosure if payments aren't kept up. Simply put, a mortgage is a type of loan that is used to buy property or land. When you buy a home you’ll typically have to put down a lump of money (called a deposit or downpayment) towards the price of your new home.

The rest of the money you owe for the home will be paid for with a mortgage. You’ll own the home even though you’ve only paid for a small amount of it, but you’ll have to make monthly repayments on your mortgage in order to keep it!

Mortgages tend to be very long term (often 20+ years!) and they tend to have fairly low interest rates. The amount of money you’re allowed to borrow for your mortgage will depend on many factors such as how much money you and anyone else purchasing the property with you earns, your credit score (we’ll talk more about this later), and other debts you currently owe. These same factors can also influence the interest rate that you’re offered, as well as things like the stock market and the current economy. And of course which country you live in and any rules they have for borrowing will also impact how much you can borrow and what the rates will be for your mortgage.

Remember: You will be charged interest on your mortgage.

So in addition to paying back the money you borrowed to purchase the home, you’ll also pay an interest fee to whichever company you’re using for your mortgage. The interest will be a percentage of the total mortgage, and as with other loans, the lower the better. With fixed rate mortgages, the same interest is charged every month for the duration of the loan term, so you’ll be charged the same amount every month for your mortgage payment. With variable rate mortgages, the interest rate will vary based on changes in the stock market and the economy, so your monthly payment may change month to month.

What is considered “Good Debt”?

Just like student loans, mortgages tend to be called “good debt”, as the money you owe is going towards a house that you will eventually own, and will hopefully increase in value over time. Some people prefer to pay their mortgages off early for peace of mind that if their financial situation changes they won’t be at risk of missing mortgage payments that lead to them losing their home.

But oftentimes the interest rates are low in comparison to other types of debt, so most people take their time paying off their mortgage and don’t rush to pay it off early even if they have the income to do so. In fact, many millionaires and billionaires use mortgages so they can put their money in the stock market to earn a higher return than the money they’d save on not paying interest on a mortgage (we’ll talk more about this later in the investing section).

In Canada, mortgages tend to be broken up into multiple terms. So if you have a 30-year mortgage, you might have an agreement to pay a 4% fixed interest rate for the first 5 years, but once those 5 years are up your interest rate may change. Some people will switch to a different mortgage provider at this point if they can find a lower interest rate with better terms.

Lending so much money can be risky business for companies, so your mortgage will be secured against your home. This means that if you fail to make your repayments, you will be at risk of losing your home.

How to avoid being “House Poor”

It's a common belief that if a bank approves you for a mortgage of a certain amount, it automatically means you can afford a house worth that much. THIS IS FALSE! The amount approved by the bank is the maximum they're willing to lend you based on your financial situation and creditworthiness (again, we’ll touch on credit scores later on). It doesn't consider your entire financial picture, like if you’ll still be able to pay for all of your expenses and if you’ll be able to save enough each month to eventually retire.

What you can truly afford goes beyond the bank's approval. If you stretch your budget to the maximum approved amount, you might find yourself "house poor." Being house poor means you're spending a significant portion of your income on housing costs, leaving little room for other expenses including “needs”, “wants”, and savings.

Additionally, purchasing a house at the maximum approved amount leaves you vulnerable to financial shocks. If interest rates rise or unexpected expenses come up, such as needing a new roof or facing a major repair, you may struggle to keep up with your mortgage payments.

It’s incredibly important to consider your personal financial situation, lifestyle, and long-term goals when determining how much house you can afford.

This often means opting for a mortgage amount that is lower than the maximum approved by the bank, ensuring you have a buffer that gives you flexibility and stability for the future. In summary, each type of debt has its own set of pros and cons. It's important to understand the terms, interest rates, and repayment options for each before diving in. Debt isn't necessarily a bad thing, but it's crucial to manage it wisely to avoid financial pitfalls down the road.

Personal Loan

Let’s say you want to renovate your kitchen but you don’t have enough money in savings to do so. A personal loan might be a great option to pay for the reno. These loans are ideal for one-time large expenses, like completing major house work, purchasing a car, paying for a much-needed vacation, or even starting a new business.

To take out a personal loan, your bank will likely ask what you’re planning to use the money for before agreeing to give you the loan. If you’re approved, you’ll receive the full amount as cash in your bank account, and then be required to pay back the loan, with interest, at a fixed rate each month. For example, you may take out a loan for $5,000 at 8% interest, and be required to pay the bank $200 per month until the loan, plus all of the accumulated interest, is paid off in full.

The interest rates on personal loans are usually much lower than credit cards, so this can be a great option if you’re in a pinch and need access to more cash (note: the interest rate you’re offered will depend on your credit score- we’ll talk about this in more detail later on).

Some people also use this type of loan to consolidate their credit cards. For example, if you have 2 credit cards with a balance of $3,000 and $5,000 at a 19% APR that you can’t pay off, you might consider taking out a personal loan so you can pay off the credit cards and instead slowly back the personal loan at half the interest rate.

Payday Loans

Have you ever been tempted by ads on the radio for payday loans? Or maybe you’ve seen signs along the road advertising “Get cash now!”. Payday loans are the WORST! You basically walk in, ask for a loan, and they’ll give you a small amount of money on the spot without too many questions.

However, you often have to pay it back very quickly (usually 2-4 weeks) and the interest fees are astronomical. They can be as high at 1500%! It makes the 14-35% interest on credit cards look like nothing. This is never a good option, and should be avoided at all costs. If you’re struggling to make ends meet and a line of credit or a credit card aren’t options for you, consider visiting your bank and talking to an advisor or looking into local charities who can help.

Cash Advances

Imagine you're in a pinch and need cash ASAP. That's where a cash advance comes in handy. With a credit card, you can get cash directly from an ATM or a bank. It's like borrowing money from your card rather than using it to buy stuff.

But here's the catch: cash advances usually come with extra fees and even higher interest rates compared to regular purchases. Plus, interest starts adding up right away, unlike with regular purchases where you usually get a grace period to pay off your bill before the month ends. So, while cash advances can be a quick fix in emergencies, they're certainly not the cheapest option. It's always best to explore other alternatives first, like using your debit card or getting a personal loan or line of credit if you can.

Car Payments

That shiny new car might seem like a dream come true, but car payments can quickly become a financial burden. While auto loans make it possible to drive off the lot without paying upfront, they also tie up your income for years to come. Plus, cars go down in value over time, so you might end up owing more than the car is worth. In fact, a new car is worth on average 10% less than what you purchased it for the minute you drive it off the lot.

So if you owe $24,000 for the car when you sign the deal, once you drive it home that day you owe $24,000 for a car that’s now only worth $21,600. And within the first year a new car can lose up to 40% of its initial value. (FYI this is why we’re both huge advocates for buying used cars, even one that’s only a year old, because you’ll save SO much money in the long run. The only time we will buy a brand new car is when wasting $10k+ is no big deal… and we’re not there yet!).

You might see “0% financing” ads for cars and wonder what it really means. Well, oftentimes it’s a way for car dealerships to incentivize people to purchase older models or slow-selling vehicles to help make space for newer inventory. Again, it’s hard to qualify for these types of loans since you’ll need an excellent credit score, so keep in mind you may not be eligible for it, or you may need someone with a higher credit score or income to co-sign for it. These types of financing deals are also usually only available for new cars, so you’ll still be hit with the huge loss of value in the car once you drive it for a year.