Understanding The Difference -Good Debt Vs. Bad Debt

On the face of it, debt is easy to understand: It’s any money you have borrowed – from the bank, a credit company, your parents – that you’ve made a promise to repay. But it’s often difficult to manage. Here’s a rundown on the one financial challenge almost everyone faces, no matter how much money you make. Remember, we see it all…

What is debt?

Personal debt simply falls into two categories. Secured debt, where the loan is backed by collateral (like your house or car), or unsecured debt, where the loan is offered on the creditworthiness of the borrower alone. Note: interest rates are typically much lower on secured debt, because the lender has something to repossess should you fail your obligations to the terms of the loan. 

The debt itself can then be divided into two categories: Revolving credit, where borrowers have a set limit they can spend and you have perpetual access to whatever you have paid off – like a credit card; and instalment credit, which is typically reserved for much larger loans and is a one-time loan that the borrower pays back with set payments over a specific period of time. 

What is “good” versus “bad” debt?

We know there is good debt and bad debt, but what exactly classifies the two? We get this question a lot from our clients. “Should I borrow money to buy a new car, or take it from my investments?” Although there are many factors at play when answering these questions, lets break down exactly what good and bad debt really means. The answer might surprise you. 

Traditionally, there’s a collective idea in Canada that mortgage debt is considered to be on the good debt side, whereas everything else is bad and that’s mainly because mortgage debt is assumed to be building a long-term asset, one that is expected to grow over time. That thought process is not wrong, we tell clients every day outside of your ability to earn an income, your house is often times one of the biggest assets you possess, and for many is in fact their pension plan. But let’s take a look at other types of debt. 

Take, for example, student loans. If economic times are bad, if you won’t be working anyhow, going into debt to go back to school could be a very good debt, if you think of debt as an investment, which admittedly isn’t easy, then investing in a master's or MBA that pays for itself in a few years via additional income is a wise use of debt. That’s provided you can and will make the payments. Anything you can’t pay is bad debt.

Debt should primarily be used to purchase a home or business, finance an education, or purchase a vehicle. It’s not practical for anyone to pay cash for any of those, so those are good uses of debt – provided the interest is manageable and you’re capable of paying the debt back. There are other uses of debt like purchasing a second home or cottage, financing for renovations etc. to which then good and bad debt should also be viewed as whether that item has any potential to generate income rather than merely deplete it. Bad debt would be considered material things you can’t afford to pay for now and have no future earning potential such as clothing, travel, entertainment. When you can’t afford to pay for these items now (withing 30 days before interest is incurred), they borrow against your future earnings, and you now have to be disciplined to pay it back.

Ask yourself, if you can’t afford it now, how will you afford it later? 

How much debt is too much?

If you absolutely need a rule no more than 30 per cent of your monthly budget be allotted to debt repayment. This percentage is what’s called your debt-to-income ratio, lower is best. 30% matches up exactly with the credit utilization percentage – the portion of your available credit that you are actually using – recommended by many money experts.
 

What happens to your debt when you die in Canada?

Another popular question we get asked a lot is “What happens to my debt when I die? The executor of your estate will first repay your debts, file your final tax returns, and then distribute remaining assets to your beneficiaries. If you have no assets, no life insurance, no investments and no property, those debts will be forgiven. It’s a misconception that your next of kin is responsible for your debt’s should there be no cash to cover the obligations. Unless someone has specifically co-signed on your accounts, neither your spouse nor children are legally responsible for your debt.

In inclosing – debt isn’t bad. The main takeaways are good debt should always be viewed as an investment tool used to build long term assets or has the ability to generate some type of return for you, including education! Bad debts are viewed as any type of consumer credit you can’t pay off in the next 30 days, ultimately borrowing against your future earnings and won’t ever give anything in return. You have to have the ability, and a plan and a budget that works and is realistic to factor in the debt payment otherwise its bad debt. It’s okay to carry an amount of debt that doesn’t otherwise hinder you if your debt payments are routinely trumping your retirement savings or emergency fund contributions, it’s safe to say you’ve acquired too much debt.