Is there good debt and what separates it from bad debt? This is one of the most asked financial questions we get on a regular basis. Unfortunately, the answer isn’t that straightforward. Sure some debt might be better than other kinds of debt but it’s really up to personal preference and where you stand financially. In order to help you decipher your current debt situation, we’ve laid out what characteristics make certain debt good or bad and how this affects your finances overall.
What Makes Some Debt Good and Some Bad?
For most people, the line that separates good debt from bad debt is a simple one. Good debt is the kind of debt that is used to grow assets. This could be an actual asset like a house, a piece of land or part of a business. It could also be a theoretical asset like an education which won’t make you any money right away but will increase the possibility of success in your future.
If your debt is not helping you grow an asset or increasing your potential to grow an asset in the future, most people would say that you have bad debt. The most common form of bad debt is consumer debt, for most people, this would be credit card debt. Debt that you’ve accumulated through buying things, items or material goods, things that probably aren’t seen as an asset.
Examples of Good Debt
If you’re really interested in improving your finances or genuinely want to live within or even below your means then no debt is the best kind of debt. But for the average Canadian, not having any kind of debt is unrealistic. Like we said before it’s really up to personal preference, some items are simply too expensive to purchase with cash and some situations simply require a loan. But just as a general guideline, here are a few types of debt that you can safely consider “good”.
- The student loan. Here’s the thing, investing in yourself and your future is always a good idea. An education is technically priceless and it could help you achieve all your goals and land you a great job with a great salary. This is obviously the best case scenario so you need to think carefully before you start taking out $100,000 worth of student loans. Investing in yourself and getting an education, those are what make this good debt. What makes this bad debt? The years it will take you to pay it off.
- The investment loan. Investing in a start-up or starting your own small business are both great reasons to get an investment loan. By running your own small business, you get the chance to be your own boss, increase your income, and see your efforts bear fruit. If you are particularly successful, you might even be able to turn your small business into a self-sustaining operation, which can be extremely satisfying as well as extremely profitable if you choose to sell.
- The mortgage. This is another type of debt that some people think is good and some think is bad. Generally speaking, purchasing a home that you can afford to make the payments on and that you’ve saved up for is not a bad idea. A “bad” mortgage is when people purchase houses that are out of their realistic price range simply because a bank approved them for a large mortgage. The housing market is unpredictable which means you aren’t guaranteed a return on your investment, but on the other hand you could potentially sell your home for more than you paid for it. The best kind of mortgage, one that you’ll definitely make money from, is one you use to purchase a rental property. You can purchase a house, rent it out and make enough to pay for the mortgage and some extra. (Learn more about debt and mortgages here)
Examples of Bad Debt
“Bad” debt is considered undesirable because it pays for products and services that will provide no return, meaning that it makes the borrower’s finances worse in the long run. This is particularly true because interest will be charged on your outstanding balances, meaning that you will pay more than the actual purchase price for something that didn’t help you build an asset or invest in your future. Here are two examples of debt that is typically considered “bad”.
- The credit card debt. Most purchases made using either credit cards or lines of credit 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. To add insult to injury, both credit cards and lines of credit tend to have high interest rates.
- The auto loan. Cars are notorious for the rate at which they lose value once they start being used, so it makes sense that car loans are considered to be bad debt. An argument can be made that cars have a significant role in your success and are an everyday necessity for the average person, but their depreciation rate combined with their high interest rates makes the auto loan a type of bad debt.
It’s up to You to Decide
It is important to remember that good loans will not always produce good results, just like how bad loans will not always produce bad results. For example, if you borrow heavily to invest in a company that declares bankruptcy shortly after, you are going to regret it even more than if you had used that money to buy something that you like. Similarly, a small car loan with low interest rates for a used but reliable car can serve you well in the short run, particularly if you live somewhere with poor access to public transportation. In the end, it’s you that needs to decide for yourself and your current financial situation what kind of debt you’re able to take on if any at all.