Test your knowledge. True or false?
1. The debt ratio is calculated by adding up your monthly payments, then dividing that amount by your monthly income.
Perfectly true. If you have $1,100 in monthly payments (housing, credit cards, car loan, student loan, condo fees, electricity, taxes) and a gross salary of $3,333 a month (before tax and deductions), your debt ratio would be 33%.
This ratio (the 33%) shows how much your monthly debt costs in relation to your income. It also helps get a picture of the current state of your finances, so you can adjust your budget, if necessary. Institutions use this ratio to calculate borrowers' ability to repay (solvency).
2. A debt ratio of less than 40% is acceptable.
It's true. While a debt ratio that is below 30% is seen as excellent, and acceptable between 30% and 35%, it becomes a worry when it goes above 40%. That could compromise approval of some loans (home, student or car loans) and make it harder to pay back your debts. Unlike your credit rating, which paints the picture of your credit history, your debt ratio is directly related to your current situation (revenue-expenses).
3. Backing a loan for someone else will affect your debt ratio.
This is also true. If you guarantee a car loan for one of your children, even if that child makes every single payment on time, your guarantee has direct consequences for your ratio.
In other words, co-signing a loan can affect your credit record. Especially if you also have to borrow: the commitment affects your debt ratio. Not to mention potential strains on the relationship if the person you co-signed for is late with a payment.
4. It is best to pay off student debt first before any other debt.
False. As a general rule, it is better to pay off debt with a higher interest rate before debt with lower interest rates, or that is deductible from income, like student loans. In fact, the interest paid on government-backed student loans - This link will open in a new window. is tax deductible.1
5. To prevent debt-generated stress, we advise an emergency fund that can cover three months of expenses.
Thumbs up! That's true. In a perfect world, you should always have access to an amount equal to three months of expenses in order to handle the unexpected: a lost job, separation, sickness, financial upheaval. Preparing when the time is right will prevent additional stress when times are not as good.
6. A credit card is a good solution to unexpected expenses.
False. Although a credit card may be a good way to deal with little emergencies, ideally, the balance (amount to pay) should be paid off before the due date in order to lower or avoid interest costs. Major unexpected expenses should not be handled with a card.
7. Making an early or higher payment on a loan in one month means a future payment can be skipped.
False. What you can decrease is the amortization period, which is the total duration of the loan, therefore lowering the interest payable. However, as long as the terms of the loan remain the same, monthly payments are required or you will be considered in arrears.
Did you know?
You can apply an additional payment of up to 15% of the initial loan to the balance of your mortgage? Example: you pay $1,000 a month. You have extra money at the end of the year and decide to pay an additional $5,000. Two things then happen: you speed up repayment, which helps reduce the amount of interest on your monthly payments. Over the long run, you can decrease the time required to pay off your loan by several months or years.
Some people prefer to contribute to an RRSP instead of putting their extra savings into paying off a mortgage. Is that advantageous? You have to compare the rates. A potential annualized return of 7% on an RRSP beats repaying a loan with an interest rate of 4%. Others will choose to make the RRSP contribution, then use the income tax refund on the mortgage.
8. To save, you simply have to spend less than you earn.
Well, yes, that is in fact very true. It's the key, the winning recipe, the magic formula! It's also true that it's not always easy to reach this goal. However, with the ability and discipline to control your savings and expenses, you will see changes in two places: your bank account, and money-related stress. If you're striving to lower your debt, meeting your financial advisor could be helpful in understanding and applying the best strategies.
1 In the form of a non-refundable provincial and federal tax credit.