Good debt versus bad debt. Is there a difference? We’ll break down the different types of debt below.
Very few people have or can earn enough money to pay cash for life’s most important purchases: a home, a car or an education. The most important consideration when buying anything on credit or taking out a loan is whether the debt incurred is good debt or bad debt.
So what is the difference between good debt and bad debt?
Good debt is seen as an investment, you are buying an asset that will grow in value or maybe generate long-term income.
Obtaining a mortgage to buy a home is usually considered good debt; firstly you need somewhere to live so instead of paying rent you are paying down the debt owed against the home. The ideal situation would be that your also home increases in market value over time, so not only are you reducing the amount owed each month by making the payments the property is also increasing in value. Mortgages also generally have lower interest rates than other debt as the lender holds the asset as security.
Taking out student loans to pay for a college education is also deemed an example of good debt as student loans typically also have a low interest rate compared to other types of debt and a college education in theory increases your value as an employee and raises your potential future income. In my mind there are many caveats to this and a lot of thought has to go into the future earning potential in the field you are studying vs the cost of education vs is it truly a field you want to spend your working life and how transferable is the education. I could talk about this subject in a lot more depth and how a lack of planning before taking out a student loan is a common problem, but this is a topic for another article.
An auto loan is another example perceived as good debt and it can be categorized so if the vehicle is essential to doing business and earning and income but vehicles are a depreciating asset so it is not in the buyer’s best interest to pay interest on a loan against an asset that is declining in value if it can be avoided.
Bad debt is debt incurred to purchase things that have no value or quickly lose their value. Bad debt is also debt that usually carries a high interest rate, such as credit card debt. The simple rule to avoid bad debt is if you can’t afford it, don’t buy it.
Payday loans / Cash advance loans are the worst kind of debt. Basically the borrower decides the amount he wants to borrow, a fee is then added to that amount and the borrower has until his next payday to pay back the loan amount, plus the original fee and any interest incurred over that period of time. Interest rates for payday loans are very deceptive and can be very misleading as the time period of the loans are so short it is only truly clear what is being charged if the interest and fees are actually annualized the same as other lending product so they can easily be compared, pay day loan annualized rates can be as high as 300 percent. If you fail to pay back the amount by your next payday, the loan basically rolls over and you incur additional fees and more interest on top of the fees and interest you have already been charged. It’s a slippery slop and hard to get out of once you are in the cycle.
The most effective ways to stay out of debt
Practically speaking it’s almost impossible for most of us to live debt-free, we can’t pay cash for our home, our cars or our children’s college educations. But easy access to credit means too many Canadians let debt become unmanageable.
Ideally, your total monthly long-term debt payments, including your mortgage, car loans and credit cards, should not exceed 36% of your gross monthly income. This is one metric mortgage lenders and bankers call TDS (total debt service ratio) and is always consider when assessing the risk of a potential borrower.
Of course, avoiding debt at any cost is not smart either if it means depleting your cash reserves completely. The challenge is learning how to judge which debt makes sense and which does not and then wisely managing the money you do borrow.
Taking on sensible debt can include financing items you absolutely need but can’t afford to pay for up front without wiping out cash reserves or liquidating all your investments. In cases where debt makes sense, only take loans for which you can easily afford the monthly payments.
Bad debt includes debt you’ve taken on for things you don’t need and can’t afford and one of the worst forms of debt but often the easiest to come by is credit-card debt, since it usually carries high interest rates and relatively low monthly payments meaning the temptation is to stay current by making the minimum payments and never paying down the debt.
So based on the above it may seem logical to use every dollar you have available to keep you debt down as low as possible, even on good debt as it will reduce the interest payments and mean you can pay off more principle, but it’s not always the best move. You need to take into consideration your need for cash reserves for emergency expenses and also what your investments are earning. If you deplete your cash reserves you become reliant on short term, easily available credit to meet unforeseen emergency expenses and the short term easily available credit is usually the highest interest rates.
The key is to first create and accurate and realistic budget. Creating a budget you can follow will reduce stress, increase savings and mean you are not reliant on high interest credit for unexpected bills.
Make budgeting easy and part of the family daily routine. Keeping track of expenses, think about how to save money and plan what to do with your savings is all part of gaining control over your financial situation and are life lessons your children will learn by how the family deals with money and aren’t skills that are taught in school but ones that will stay with them forthe rest of their lives and skills they learn by being involved in the family budget and decisions on how to spend money.
The best way to understand how to budget is to understand what you are spending your money on. There are no short cuts to becoming financial accountable for your lifestyle choices so save all your receipts and add them all up at the end of the week. This now matches your budget with your lifestyle. It doesn’t matter what your lifestyle is as long as you create a budget that fits with your income and allows you achieve your financial goals.
The goal of any good budget is to figure out ways to maintain your current lifestyle by spending less money. This allows you to enjoy the things that give you pleasure in life but ensures you aren’t using credit to fund them.
Some expenses are easier to reduce than others. Things like car loans, rent or mortgage payments and credit card payments all have set payment plans making them hard to change. The goal is to focus your attention on your discretionary expenses, the ones that you make a choice on every day and understand how those choices effect you long term financial goals.
Monitoring and maintain your credit score
This is an important part of your overall financial plan. Understanding how to read your credit report and maintain a good credit score will allow you to access good credit at the lowest rates possible meaning less overall cost to acquire appreciating assets but also means even “bad credit” is available at favorable rates in the case of emergencies ensuring it is paid of sooner and before it becomes unmanageable.
Far too many people experience difficulties and sometimes embarrassment because of having bad credit and this could be avoided through proper monitoring of your credit report. For more information visit www.ecreditbuilder.ca
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