A recent report from Statistics Canada shows that Canadian families now owe nearly $1.65, on average, for every dollar of after-tax income they earn. This is leaving many households vulnerable to economic shocks such as job losses, interest rate hikes or a sudden slide in house prices.
There is no such thing as good debt or bad debt. Debt is a debt, which means you owe somebody or some company money. Too much debt is never a good thing, be it good debt or bad debt. However, avoiding debt at any cost is not smart either if it means depleting your cash reserves for emergencies.
The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money you do borrow. The standard definition for good debt is debt that helps you to make more money, while bad debt is one that makes you poorer.
For example, when you use debt to finance consumable items, you aren’t accumulating good debt. Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never accumulate debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, you should pay the balance in full each month.
On the other hand, a home purchase can be considered good debt. Since homes usually appreciate in value, the mortgage loan you take out to pay for the home is an investment. Another example of good debt is a student loan taken out to finance a college education. Earning a college degree usually means that you’ll make more money over your lifetime.
There are some books which term car loans as one of the bad debts. The financing costs of a car are indeed high, coupled with depreciation of the car and maintenance makes car ownership a very expensive affair. However, if the car is the tool that helps you to make money, it’s a form of transportation to get you to various workplaces. Perhaps the fact that you own a nice car helps to build confidence in your clients so you can close more sales. Would it still be bad debt? Or is it now good debt?
Many times a good debt can turn into bad debt overnight. For example, a mortgage loan used to purchase a property which later crashed in value by 30%. The good debt was raised for an investment, but it turned into bad debt because now the house is worth less than the value of the housing loan you owe to the bank.
It’s usually a good idea to focus on paying off your bad debts first. Since they provide no value, they are more costly than your good debts. You should pay off credit cards and auto loans before tackling mortgages or student loans.
Some people consider using good debt to pay off bad debt, like getting a mortgage for $110,000 instead of $100,000 and using the extra to pay off credit card balances. This isn’t a good idea for several reasons. First, repaying debt with debt is never a good idea. Second, it ends up taking longer to pay off the mortgage than it would have otherwise. Third, the higher mortgage increases your monthly payments and the time it takes to build equity in your home. Use cash to repay debts, not more debt.
The key thing before incurring debt is to fully understand what the money from the debt is used to pay for and the impact it has on you financially in the long run. If the debt is used to purchase an asset, make sure that the utility or financial return from the asset is higher than the cost of debt. It is also important to ensure that you are not overleveraged where your borrowings exceed your assets or where you have trouble servicing the loans. Any debt which is taken after you are overleveraged is not advisable, regardless of its purpose.
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