As plans and desires pile up, it can sometimes seem difficult to get a handle on your financial commitments. Using financing products isn’t necessarily a bad thing, but you need to stay in control of your budget and obligations. Read on for 8 common ideas about debt—some true and some false—and advice on how you can avoid taking on too much.
Test your knowledge: true or false?
1. To keep money-related stress to a minimum, you should have an emergency fund that can cover 3 months of expenses. True or false?
Thumbs up! That’s true. In a perfect world, you should always have access to an amount equal to 3 months of expenses in order to handle the unexpected: a lost job, separation, sickness, financial upheaval. Remember though, it’s never too late to get started! When you can, open an account to be your designated emergency fund, then set up regular automatic deposits.
2. A credit card is a good solution for unexpected expenses. True or false?
False. Although credit cards can be handy for minor emergencies, if you don’t pay the full balance (amount owing) by the due date every month, you’ll get hit with interest charges. Major unexpected expenses should not be handled with a card.
If you think your credit card is your only option, speak to your financial institution: they can tell you about other options that could help you pay off your card faster and get a lower interest rate.
If you’re not able to pay off your credit card in full every month, choose a card with a low interest rate. Over the medium and long term, even a slightly lower rate could save you hundreds—or even thousands—of dollars.
3. If you make an extra payment or pay a higher amount one month, you can skip your payment the next month. True or false?
False. What you can decrease is the amortization period, which is the total duration of the loan, therefore lowering the interest payable. However, unless you change the terms of your loan, you still have to make your monthly payments, otherwise it will be considered a late payment.
4. Your debt-to-income ratio is calculated by adding up your monthly debt payments and dividing that amount by your monthly income. True or false?
True. Let’s say you have monthly payments of $ 1,800 (things like rent or mortgage, insurance, credit cards, loans, utilities and taxes) and a gross monthly salary of $ 5,000 (before taxes and deductions), your debt-to-income ratio would be 36%.
Your debt-to-income ratio (the 36%) tells you how much of your monthly income goes to paying back debt. It can also help you see if you’re getting in over your head, so you can adjust your budget as needed. Financial institutions use this ratio to calculate your ability to repay your debt (your creditworthiness).
The lower your ratio, the easier it should be for you to make your payments. If you’re worried about your debts, start by taking a look at your budget. Calculate your debt-to-income ratio, then see if you can cut any unnecessary expenses. You can also figure out which debts you should pay off first.
For help making your budget, use the Your budget tool.
5. A debt-to-income ratio under 40% is generally considered okay. True or false?
True. As a general rule, a debt-to-income ratio under 30% is considered excellent, while a ratio between 30 % and 36 % is considered okay. Things get a little worrisome if your ratio goes over 40%. A higher debt-to-income ratio means you might not get approved for a loan (like a mortgage, student loan or car loan) and you could have a harder time paying it back. Unlike your credit score., which is based on your credit history, your debt ratio is based on your current situation (income and expenses).
6. A debt-to-income ratio is the same as a credit rating. True or false?
False. As mentioned above, the debt-to-income ratio takes into account your expenses and income. The credit rating, on the other hand, is the equivalent of a 3-digit rating varying from 300 to 900 granted by credit rating agencies based on, among other things, your repayment habits. The more often you make your payments on time, the higher your credit score will be.
7. Co-signing a loan will affect your debt-to-income ratio. True or false?
True again! For example, if you co-sign a car loan for one of your kids, even if they make every single payment on time, your debt-to-income ratio will be affected since the amount of this financing will be added to your credit file.
In other words, co-signing a loan affects your creditworthiness—which could be an issue if you also need a loan. That’s because the loan you co-signed is included in your debt-to-income ratio. Of course, things could also become tense if the person you co-signed for is late on their payments.
8. Student debt should be paid off before any other debt. True or false?
False. As a general rule, it’s better to pay off debts with higher interest rates before debts with lower interest rates or those with tax-deductible interest—like student loans. In fact, interest paid on government-guaranteed student loans is tax deductible.1