Most people know what debt is, but not everyone understands what kind of debt they have and if this debt is helpful or a hindrance to their financial goals.
Frederick & Company is here to give you the knowledge and advice you need to effectively manage your debts to pave the way to financial freedom. Not all debts are bad – some help us to acquire homes and other assets – however, there are some kinds of debts that weigh you down financially without providing you with an ongoing benefit.
What is Consumer Debt?
Consumer debt is a term used to describe personal debts used for purchasing goods for individual or household consumption and can include personal loans, credit cards, car or recreational vehicle loans, and student loans. Personal debt excluded from “consumer debt” is only mortgages or securities on your home.
Consumer debts also do not include debts used for investments, running a business, or amounts owed to the government.
Different Debts Can Impact Your Credit Differently
Different types of consumer debt can impact your credit score differently.
For example, if you have a credit card, your credit utilization rate will affect your credit score while debt owing to Canada Revenue Agency does not even appear on your credit bureau.
There are ongoing obligations, such as your utilities or cell phone bill, that will report negatively to your credit bureau but do not report positively when you are making your payments on time. It is important to understand how credit use and credit repayment for each different credit type can impact your credit rating and thus your ability to successfully apply for future credit.
While having a diverse credit history with a mix of different types of Canadian consumer debt can be beneficial for your credit rating and credit score (LINK TO ARTICLE ABOUT CREDIT), understanding how each one works is important in avoiding issues with misuse of credit and debt issues down the road.
When a lender is considering giving you a loan they will usually do a credit check to see how responsible you have been when it comes to the applicant handling payments in the past; have you had a good history of making payments on time? Have you successfully completed a similar kind of loan in the past? What is your total credit availability and if you used all this credit would it make it hard to pay back the new loan? What is your credit available in comparison to the amount of income you have to support the debt payments?
With this information, a creditor will determine whether they will give you the loan and what interest rate they will charge to lend you the money.
What are Some Different Types of Consumer Debt?
Let’s take a look at the types of consumer debt in Canada:
Secured debts are debts that are backed by a collateral asset, which means that the borrower pledges something as security should the loan go unpaid.
For instance, when you get a car loan to purchase a car, the car itself becomes collateral. If you don’t pay your car loan, the bank can seize the car to satisfy the loan. They can then report this to the credit bureaus and put a negative mark on your credit rating which can stay there and impact your credit rating for many years.
When it comes to qualifying for secured loans, lenders will offer lending based on your credit history and the value of the collateral, so it’s important to build your credit to qualify for better interest rates for loans.
Also known as signature loans, unsecured debts are simply debts that aren’t secured to collateral and the lender provides the loan on faith that you will repay it. The terms of the agreement dictate that should you fail to repay the loan the lender can pursue legal action against you as their only remedy for collecting.
There is no specific collateral to seize to satisfy an unsecured loan which is why unsecured debts often have higher interest rates – it will take additional expense and effort on the part of the creditor to go through the legal process to pursue you if you do not make the payments as agreed.
The lender has the option to sue you and obtain a judgment against you should you fail to pay the loan. Once a judgment is granted the bank can issue a writ of enforcement to garnish your wages, garnish your bank account, seize your property, and/or register that writ of enforcement with the Personal Property Registry or Land Titles.
Revolving debt is the most common type of consumer debt in Canada that involves an arrangement where you have access to credit – up to a maximum limit – and you may use (or not use) this credit as you see fit and the repayment of this debt will be determined by the amount you have used of that credit, at any given time
Credit cards and lines of credit are examples of unsecured revolving debt, but revolving debt can also be secured, such as home equity lines of credit.
Consumers are free to spend any amount below the limit until the limit is reached. For repayment, they can repay the balance in full for each cycle (usually monthly) or make smaller regular payments However, not paying the full amount each cycle will result in interest charges being incurred, meaning you’ll be required to pay back what you borrow plus an additional charge..
You need to be a good money manager when using revolving credit. When using revolving debt you need to have a plan on how you are going to pay off the debt as the lender will not require anything more than interest-only payments. With the minimum payment of interest only you will be stuck with this debt indefinitely if you pay at the rate suggested by the creditor on your credit card bill or line of credit.
Secured lines of credit on your home (“HELOC”) can be for a large amount of money – even though the interest rate can be lower than an unsecured line of credit you can end up paying a lot more in interest because of the size of the loan. If you are paying interest only on this loan then over the long term you will be paying significantly more than you would on a higher-interest mortgage because with a mortgage you are paying down the principal loan amount each month whereas the HELOC loan amount never decreases unless you pay more than the minimum payment.
If you’re mindful of your spending and budgeting and have the ability to pay the interest and the principal off over time this type of debt can be used to get you through the short-term pinch or a home renovation, in the case of a HELOC. But, if you have a hard time keeping your spending under control revolving lines of credit can lead to overextending and being unable to pay off your debts as they come due. In the case of a HELOC, it can keep you in a position where you are never building equity in your house which could impact your ability to meet your overall financial goals.
While credit cards will have a minimum interest rate the lender can opt to increase the interest payable if you miss your payments so making your payment each and every month is never important.
Lines of credit are most often tied to the prime rate which will fluctuate based on the Bank of Canada rate. For example in 2022 and 2023 we saw the Bank of Canada increase its interest rate. When this happens lines of credit – whose interest is based on the prime rate – will see a similar increase to their line of credit interest rate. This will impact those minimum payments that need to be paid each and every month just to maintain the current balance of the debt.
Mortgages are the most common secured debts in Canada and are available when you are purchasing a home, and it will likely be the largest loan you will take out in your lifetime and over the term of the mortgage.
While this seems like a very large commitment – which it is – it may actually reduce your monthly housing expenses over time as you pay off your mortgage over time, and build equity in your house.
When you get a mortgage, your contract will be for a term of 1,3, or 5 years typically and you will need to renew for additional terms until you can pay the balance in full. The renewal of a mortgage will come around at the expiry of the current term and the subsequent term will result in a lower principal owing however the interest rates will be based on the market rates at the time of the renewal as well as the individual’s personal credit rating history. This means that your mortgage interest rate could go up or down at renewal and you should be prepared to adjust your budget accordingly.
Homeowners that received a mortgage when they had a poor credit rating may find that when they renew their mortgage at the end of the term they may have more bargaining power when reviewing their interest rates and payments if their first term was based on unfavorable factors, such as a poor credit rating or a high prime rate.
As a secured debt, the home itself serves as collateral, which means that borrowers can lose their home if the mortgage is unpaid. The process of seizing the home because of failure to pay is known as foreclosure. If you’re experiencing difficulties paying your mortgage, it’s important to contact your lender as soon as possible to explore your options, including a payment arrangement.
If you’re concerned about your financial circumstances overall, reach out to a local licensed insolvency trustee or other trusted debt professional to discuss your finances. If you have other debts that are impacting your budget a licensed insolvency trustee can review options for dealing with those other unsecured debts so you are better able to manage your mortgage payments moving forward.
There are numerous external factors that affect the interest rate for a mortgage including the Bank of Canada interest rate and the terms specific to the mortgage you have applied for but lenders will take into consideration your personal characteristics as well, including your credit history, income, and employment history. It’s also important to seek out a mortgage broker who can perform extensive research and shop around for lenders to get a deal that is suitable for you and your needs. Make sure to tell your mortgage broker about any renos you are planning, how long you want to live in the property, etc. so they can find mortgage terms that are best suited for your situation. The interest rate is just one such term that should be considered when you are looking at a mortgage. Other terms include balloon payment options, mortgage cancellation fees among others.
Trends in Consumer Debt in Canada
With these different types of debt, what does this look like for Canadians?
According to Equifax, the total consumer debt in Canada reached $2.36 trillion by the end of 2022.
Factors like population growth, the pandemic, and increased living costs have caused more Canadians to seek and use credit.
Consumers tend to rely on credit during tough times, and financial stress is causing more individuals to take on more debt. When you have credit, which you maintain a monthly payment for, you are intrinsically agreeing to pay more for the convenience of buying something immediately. Unfortunately relying on credit when times are tight is actually a strategy that can backfire because when you have very little money paying more isn’t going to help you in the long run.
Examples and Statistics
- Non-mortgage debt per consumer reached a yearly amount of $21,183 (the highest since the beginning of 2020).
- New-to-credit consumers increased by 37.4% compared to 2021.
- At the end of 2022, almost 1.5 million new credit cards were issued, and the average credit card spend per borrower was $2,447.
When Should I Be Concerned with My Consumer Debt?
Even though many Canadians deal with debt, having consumer debt is not necessarily a bad thing.
Managing your credit rating debt can help you build good credit and managing your credit effectively includes:
- Paying down your credit cards every month, bringing the balance to zero
- Maintain a balance on your credit cards and lines of credit at less than 50% of the available credit
- Avoiding adding additional debt if you are struggling to pay the debt you have
- Pay your bills on time.
- Do not miss any monthly payments: making lump sum payments and then making no payment for a few months, then a large lump sum payment will have a bad impact on your credit even if you actually paid them back more. Regular monthly payments are a must.
Create a Payment Strategy
Without a plan, However, debt can build to an unmanageable level and easily spiral out of control.
To tackle your consumer debt, here are some payment strategies you can try to reduce what you owe:
- More Than Minimum: Pay more than the monthly minimum to pay down the loan quicker and avoid unnecessary interest payments.
- Snowball: Prioritize your debts and pay off the smallest ones first. This sense of accomplishment will motivate you to eliminate your debt.
- Avalanche: List your debts and pay off the loan with the highest interest rate.
- Automate: Automate your loan payments through your bank to avoid missing payments and late fees.
Make a Budget
If you are struggling to find money to pay down your consumer debt, it may be time to sit down and make a budget.
A simple and effective budget includes tracking your income and expenses to see where you are spending your money.
From there, you can cut down on spending and free up funds to pay down your debts. There are numerous resources out there to help you budget such as the Government of Canada Budget Service.
When making a plan to pay your debts make sure you are making a plan to pay off your debts. Paying minimum payments will result in maintaining these debts indefinitely – instead, we want to make a plan that will eliminate your debts.
A consumer proposal is a formal offer to your creditors to settle your unsecured debts by paying a portion of the total debt. It is a legally binding process overseen by the government and is administered through a licensed insolvency trustee that can result in a reduced payment which eliminates unsecured debt at the end of the process.
A consumer proposal allows you to have predictable and affordable monthly payments based on your income or a lump sum payment to resolve your unsecured debts.
This can be an option to explore if you have overwhelming debts that you cannot pay off on your own.
Are You Ready to Get Started?
Frederick & Company is a licensed insolvency trustee and we offer private and no-obligation consultations to help you explore your options and get back on track with your finances.