There is an abundance of coverage in the news these days about how Canadian household debt has climbed steadily in recent years and hit record levels, fueled by mortgages and low interest rates. While debt is generally perceived as bad, some debt is necessary and if well managed, can be an asset. When looking at your debt, it’s important to understand good and bad debt and make sure you are making sound choices for your financial future.
Traditionally, there is certain debt that is considered to be good. Generally, good debt helps you gain wealth or income. It’s an investment that gains value over time and improves your quality of life. Examples include:
Mortgages. A mortgage helps you build equity in real estate. It’s considered an appreciating asset that will make you wealthier in the future. Using debt to finance assets—like real estate and retirement savings—that grow over time might be a wise investment. However, it is crucial to get professional unbiased advice on these matters. Markets can turn into a downward spiral and money borrowed to invest will have compound interest charged on it. Borrowing to build wealth is not simple, and because of this, many people end up losing wealth, or simply pay more interest on the money borrowed when compared to the appreciation of the asset.
Student Loans. A loan towards pursuing education is an investment in your future. It can help you increase your earning power and future net worth. In saying that, much research and care needs to go into this decision as a student loan that yields a job in a low paying industry may take many years to pay off.
Business/Investment Loans. A business loan can give you the boost you need to launch and run your own business. Being your own boss can provide great job satisfaction and increase your income.
Bad debt is money spent on goods that are consumed over time and provide no return. It is debt taken on to buy something that depreciates in value or that you can’t repay on time and in full, incurring interest charges and more debt. Examples include:
Credit Cards. Credit card purchases are considered bad because they are often used to purchase items that are consumed right away or that start losing value as soon as they are purchased. A new TV, set of golf clubs, expensive concert tickets or a vacation you can’t really afford are all examples. Credit cards also tend to have high interest rates. Interest charged on outstanding balances means you end up paying more than the actual purchase price.
Payday Loans. Payday loans are never a good idea. Aside from credit card debt, they are about the worse type of debt you can carry. They are usually short term with extremely high interest rates and high fees. It’s crucial to repay payday loans as soon as possible because of additional fees accrued when you fail to pay. People often turn to these when desperate and out of a better alternative, becoming further stuck in a cycle of debt.
Auto Loans. Vehicles lose value the moment you drive them off the lot. Their depreciation rate combined with high interest rates makes an auto loan a type of bad debt. Since most people require a car and may not have cash to purchase it, you are better to buy a used car with low miles than an expensive new one.
Debt can be good or bad, and good debt can turn into bad debt. It’s important to figure out what is right for you, and to focus debt on long-term assets and immediate needs, rather than wants and impulse purchases. Review your spending habits, where your current debt falls to see where you can best eliminate debt, and what you can do to reduce bad debt going forward.