It would be nice to eventually become debt-free and avoid having to pay bills every month. But the truth is, some types of debt are not all that bad. In fact, there are certain types of debt that can actually be advantageous to us over time. The challenge lies in distinguishing good debt vs. bad debt and managing your good debt shrewdly.
Before you take out a loan, it’s helpful to distinguish it as either “good” or “bad” debt, as one can sink you into a financial hole, while the other can provide you with financial advantages.
Good Debt vs. Bad Debt
To help you decipher your current debt situation, we’ve laid out what characteristics make certain debts good vs bad.
Good Debt vs. Bad Debt: What Makes Debt “Good”?
Good debt can be any type of debt that increases the value of an asset or helps you build wealth over time. In many cases, it takes money to make money, and good debt refers to taking on debt that can help you generate an income or achieve more wealth in the long run.
Some common forms of debt that are regarded as good debts are:
- Business loans
- Student loans
- Mortgages
- Investment property loans
However, it’s important to keep in mind that they could turn into bad debts if the circumstances aren’t suitable. Nothing is absolute or guaranteed to manifest as good debt because market conditions, interest rates, and numerous other variables can change over time.
Good Debt vs. Bad Debt: What Makes Debt “Bad”?
Bad debt refers to any debt that you’ve taken on to buy items that don’t increase in value over time or decrease in value soon after being purchased. Unlike good debt, bad debt adds more financial liability to your profile without the benefit of helping you leverage the debt to increase your net worth.
Good Debt vs. Bad Debt: Types Of Good Debt
Here are some types of debt that can be considered positive if used effectively:
Mortgages
Taking on a mortgage to buy a home is one of the biggest expenses that Canadians have. In most cases, you’re looking at hundreds of thousands of dollars in debt that you need to pay back, plus interest.
But despite this massive debt load, a mortgage means you’re able to purchase an asset of great value that usually appreciates over time. Over the years, your home will grow in value and will allow you to build equity. If you ever sell your home at some point in the future, you will likely see significant profits thanks to the growth in your home’s value.
Moreover, you can tap into your home equity to access large sums of money with low-interest rates. These loans can be used to cover a big expense such as home renovations, which would further increase your home value. As such, that original mortgage you took out can help you add a valuable asset to your financial portfolio.
When Can A Mortgage Turn Into “Bad” Debt?
Mortgages can sometimes become bad debts. When you purchase a home the plan is for the home to increase in value, but occasionally the opposite occurs. Sometimes a community will turn undesirable with time, or something gets constructed in close proximity to the property that triggers property values to decline.
Similarly, a mortgage can turn into bad debt if you purchase a house that is out of your realistic price range simply because a bank approved you for a large mortgage. The housing market is unpredictable which means you aren’t guaranteed a return on your investment.
Investment Properties
Buying an investment property also involves taking out a mortgage, but rather than financing your family home, you’d be financing a rental property that can help you build wealth in a slightly different way. While financing an investment property may require a significant financial commitment upfront, you’ll be able to leverage the property you get from that to generate a regular income every month.
If you crunch the numbers properly and choose the right property, the rent you collect every month can more than cover the mortgage you took out to finance the purchase.
Even if you’re not making any more than you’re spending every month on the property, the rent is still covering the mortgage and all other expenses, leaving you with an asset that will be much more valuable in a few years compared to when you first bought it. In this way, the debt you took on to finance this purchase can be considered “good” debt.
Student Debt
A college diploma or university degree is frequently regarded as good debt because it’s an investment in your future. Individuals with diplomas or degrees are more employable than their counterparts without a post-secondary education and typically earn much higher salaries.
Currently, it’s estimated that about $28 billion is owed in government-funded student loans by Canadian graduates, with university students owing on average $16,727 by the time they graduate.
Paying off thousands of dollars in student loan debt after graduation can seem overwhelming. But spending money on an education that can eventually bring about a good-paying job can be considered money well spent. Depending on the field of study, college or university grads may have the chance to earn a much better income than those with only a high school diploma.
According to a report by Statistics Canada, both men and women with a bachelor’s degree earned more than those with a college degree and high school diploma. Women earned 58% more than women with only a high school education.
Business Loans
A well-run business in a solid niche can break the income ceiling and allow you to earn a significant income. But starting and running a business takes money, which many Canadians might not have.
With the help of a business loan, you can get access to the funds you need to start a successful business that will generate an income that wouldn’t have been able to earn without that initial financial boost. As such, a business loan can be considered good debt because they are an investment in your potential as a business owner. As your business grows, it will hopefully become worth considerably more than the original loan.
Good vs. Bad Debt: Types Of Bad Debt
Debt has traditionally had a negative connotation to it, even though there are plenty of examples of good debt that can be an asset to your financial portfolio. But there are plenty of other types of debt that can leave you with little to show for, including the following.
Why Is Credit Card Debt Considered Bad Debt?
While credit card debt isn’t inherently bad, they are one of the worst types of debt simply because of the sky-high interest rates that come with it. Moreover, credit cards often lead to bad debt because of the following:
Temptation To Spend More
Credit cards are one of the easiest credit products to qualify for. With convenient and easy access to credit, the temptation of spending money that you don’t have becomes hard to resist. Further, the money that you spend on credit is usually used to buy items that quickly diminish in value right after buying them.
Minimum Payments Increase Cost
Credit card minimum payments can trap unsuspecting borrowers into a cycle of debt. While minimum payments allow you to avoid penalties, your balance continues to accrue interest. So, you end up spending a lot more money than you would by simply purchasing the goods or services outright. All that interest adds up, and the more your credit card debt mounts, the more you’re spending in interest.
If you’re not careful, you could find yourself at a point where you may find it nearly impossible to climb out of all that credit card debt.
It’s Used To Buy Items That Lose Value
Most purchases made using credit cards are considered to be bad debt because they will lower your wealth. For example, if you buy a flat-screen TV with your credit card, it will start losing value as soon as it exchanges hands because technological advancement will make it less and less desirable as time passes even without taking into account the accumulation of wear and tear.
Why Are Payday Loans Considered Bad Debt?
Even worse than credit card debt is payday loan debt. These types of loans are typically taken out by borrowers who find themselves in a financial predicament. Usually, a lump sum of cash is needed immediately to cover a pressing expense. These loans are relatively easy to get approved for. This is why they’re attractive to those who don’t have the credentials to get approved for other loan types.
Payday Loans Have Extremely High Interest Rates
Unfortunately, the ease of getting these types of loans comes at a price. Interest rates on payday loans are usually exceptionally high compared to other loan types. Further, payday loans have a very short repayment schedule and are usually due within a couple of weeks, or when the borrower receives their next paycheque.
Payday Loans Have Short Terms
Given the quick turnaround of these types of loans, many borrowers may find themselves unable to repay their debt by the due date. To come up with the money needed to pay the loan back, they reapply for a new payday loan. This can spark an unending “payday loan cycle” that gets increasingly difficult to get out of.
For this reason, payday loans should only be considered as a last resort and only if you’re confident that you’ll be capable of repaying the loan by the due date.
Why Can Car Loans Be Considered Bad Debt?
Having a car to get you from point A to point B is often a necessity in life. Especially if you live in more remote parts where public transit isn’t readily available. But buying a vehicle in an all-cash deal can be a tall order for most Canadians given the high price of cars these days. That’s where auto loans can come in handy.
Cars Depreciate
While a car loan may be essential for you, it can be classified as “bad” debt simply because the asset you’re buying will immediately start to depreciate as soon as you drive it off the dealer’s lot. And over time, the car will continue to decline in value, sometimes resulting in negative equity.
Car Loans Often Have High Rates
Because cars are more often than not necessities, consumers are willing to take on more debt than they should and at higher rates than they should. This leads to high monthly payments with longer terms to combat a higher interest rate. Car loan debt can last for up to seven years. At the end of those seven years, you’ll have nothing to show for it, except an older car.
How To Avoid Bad Debt
Before you spend money on something, consider the following:
How You Will Benefit From The Purchase
Of course, your home and your car are important, but even then, you’ll want to make sure you’re not spending more than you can afford. When it comes to other things, be sure you’re not spending your money frivolously and putting your expenditures on credit without justification. Ask yourself whether the debt you’ll be adding to the books is going to benefit you long-term or if it’s just going to offer instant gratification.
Keep Credit Card Spending Low
If you’re spending on your credit card, try to keep your credit utilization ratio — which is the amount you spend on your credit card relative to your credit limit — below 30%. This is the recommended amount experts advise to help keep your credit score healthy.
Save Up For An Emergency Fund
Rather than depending on a quick loan when you need to cover a big expense, an emergency fund can give you access to the money you need. Having one can reduce your need to rely on loans and can help you avoid getting trapped in sky-high interest payments.
Pay Your Bills On Time
If you want to avoid paying more interest than necessary, make sure your bills are paid on time every month. This will also help ensure a strong credit score, which will come in handy when applying for loans and credit products in the future.
Final Thoughts
Not all debt is created equal. While most debt might not always be a good thing for your financial profile, other debt can help you build significant wealth over time. Like all types of debt, however, it’s important to make sure you’re financially capable of taking on extra debt so you don’t get in over your head.
