Good debt vs. bad debt
Debt is one of the most searched for financial terms, the top financial struggle for most Canadian families and the most feared financial term. In the world of personal finance, it’s the four-letter word. It is also a catalyst for taking action, a tool to change your money game, and a chance to optimize your finances. This article is our way to show you the good and bad of debt, and how you can make it work for you.
The origin story:
For many of us, our feelings about debt stem from our upbringing. What did our parents teach us? What experiences did we go through? These were the foundations of our money personalities. Reading this article may cause some friction with those beliefs. Learning sometimes means we have to first “unlearn” the limiting beliefs we started off with. For instance, being the generation that graduated from university at the time of the financial crisis, a lot of the money gurus we hear from today (on TV or on Instagram) will preach a “No Debt Ever” policy. If you look at those cases more closely, those are situations where debt had become an uncontrollable addiction, as opposed to a financial planning tool. Of course, in those cases, eliminating debt as an option would be wise. But this course of action doesn’t ring true for everyone.
This article is going to show you that, despite the common beliefs, there is such a thing as “good debt” and that debt is not something to be feared. It will also show you the kind of debt that can be destructive and help you understand the difference.
Good debt is taken on consciously. This means you understand why. Good debt helps you reach a goal, which isn’t a consumption-based goal. A consumption-based goal would be taking on credit card debt to fund a vacation that you can’t afford. A conscious goal would be taking an RRSP loan (at a favourable rate) and using the funds to fill your RRSP room, obtain a refund and pay off the debt at a higher rate.
The key with good debt is to keep in mind that we can obtain it, even if we can’t afford it. So it really is our responsibility to know what to take on. Don’t let your growing income lull you into a false sense of safety. In our experience, high earners that overspend get into the same debt issues, often at a higher and more damaging degree!
Here are some first steps to help you evaluate whether the debt you have is good or bad:
1. Could you access these funds at a lower rate of interest? Often, we see members relying on credit cards and credit card debt instead of applying for a line of credit from the bank.
2. Is it high-interest credit card debt? There are virtually no instances where this is a good idea.
3. Is the debt serving as an investment that will pay off with certainty at a later date? For example, if you are buying a piece of equipment that will allow you to earn more over the short and long term, then, as long as you can plan for how you will pay it off and as long as you believe you can stick to that plan, then it is a scenario where debt makes sense.
4. Is the debt a real estate investment? Most people would automatically categorize a mortgage as a “good debt” option. I mean, real estate is always safe, right? Well, not really. Mortgage debt only makes sense if you can pay it off AND if the underlying asset (in this case, the house) remains at the same value or increases in value. Otherwise, you’re going to lose money in the end. That being said, consolidating your debt into a mortgage will give you one easy payment at a rate you can afford. This is an excellent strategy.
5. Are you borrowing for investment purposes? This might be something you encounter at a higher level, but the principles remain the same. This is a risky move and one that should be taken cautiously with full understanding. The key principle is mitigating the risk, which means knowing how you would respond if the investment doesn’t work out. Can you continue to make payments on that debt? What if something happens to you? Are you adequately covered with insurance to be able to manage it? This could be a disability, and illness or a death.
Debt is commonplace in Canada and the media paints a picture of doom. We want to ensure you understand the difference between impulsive consumer-driven “bad debt” vs. strategic, well understood and planned for “good debt”. Here’s a quiz you can take to test your knowledge.
What are some of your debt questions? Let us know in the comments below.