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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 from 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 actually provide you with financial advantages.
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 over the long run.
In this way, some types of debt can actually improve your financial situation, even if it means carrying a certain debt load. Some common forms of debt that are regarded as good debts are business loans, student loans, mortgages, and investment property loans.
However, it’s important to keep in mind that they could possibly 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.
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 wealth.
Types of Good Debt
Here are some types of debt that can be considered positive if used effectively:
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 will appreciate over time. Over the years, your home will grow in value and will allow you to build your 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.
And if you hold on to your home for the long haul, you may have enough equity to tap into if you ever need a large sum of money to cover a big expense. As such, that original mortgage you took out can help you add a valuable asset to your portfolio.
With that in mind, mortgages can sometimes become bad debts. When people 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.
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.
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.
A well-run business in a solid niche can break the income ceiling and afford you the opportunity 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 you may not 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.
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.
One of the worst types of debt is credit card debt, simply because of the sky-high interest rates that come with it and the temptation of spending money that you don’t have in your hand. Further, the money that you spend on credit is usually used to buy items that quickly diminish in value right after buying them.
What’s worse, if you carry a balance month after month, you’re 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. And 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.
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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.
But 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 in value 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.
Even worse than credit card debt is payday loan debt. These types of loans are taken out by borrowers who find themselves in a financial predicament in which they need a lump sum of cash right away to cover a pressing expense. These loans are relatively easy to get approved for, which is why they’re attractive to those who don’t have the credentials to get approved for other loan types.
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 until the borrower receives their next paycheque.
Given the quick turnaround of these types of loans, many borrowers may find that they are unable to repay their debt by the due date. In order to come up with the money needed to pay the loan back, they end up reapplying 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.
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 in life, but even then, you’ll want to make sure that you’re not spending any more than you can afford. When it comes to other things, be sure that 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 that will fizzle out shortly after.
- 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 having to pay 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 it comes time to apply for loan and credit products in the future.
Can good debt affect your credit negatively?
Is debt used to invest a good idea?
How much debt is okay to have?
Not all debt is created equal. While most debt might not always be a good thing for your financial profile, others can actually help you build significant wealth over time. Like all types of debt, however, it’s important to make sure that you’re financially capable of taking on extra debt so you don’t get in over your head.
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