Good debt Versus Bad debt
Not all debt is created equal, and knowing the difference between good debt and bad debt is key to debt management.
There are generally two reasons you might want to take on debt, firstly to help you afford something you don’t currently have the money to pay for, and secondly to invest the money when the cost of borrowing is less than the expected returns of your investment. This second reason for borrowing is commonly referred to as using leverage and we’ve written an introductory guide to how you can use it to grow your portfolio here.
Common forms of debt that most people use at some point in their lives include credit cards, student loans, and a mortgage.
So how do you determine whether something is good debt or bad debt?
Well, it’s not black and white and there are a variety of factors you’ll want to take into account when deciding whether it’s a good idea to borrow money. First of all, and most importantly, you’ll want to take into account the interest rate of the debt. You may have heard that it’s important to stay away from high interest debt, but what does that mean? While there’s no clear definition on what exactly “high interest” refers to, especially with interest rates changing over time, one thing is clear: you should always access the cheapest form of debt first. It would be unwise to take out a personal line of credit at an interest rate of 10% when you could access a HELOC at a lower rate for example. An easy trap to fall into is the concept of “mental accounting”, so try and remember that all of your assets and liabilities are a part of the same portfolio that is your net worth. Always pay off your highest interest rate debt first, regardless of where it is.
Generally the cheapest forms of debt available are real estate backed borrowing in the form of a mortgage or a HELOC, and student loans, which are currently interest free in Canada (at least the federal portion).
Speaking of student loans, let’s talk about another factor that plays an important role in determining whether debt is good or bad: the purpose for borrowing.
If you’re borrowing money to help you pay for something that’s likely to help your financial goals, that moves it towards the good side of the scale. Investing in your education to increase your lifetime earnings by taking on student loans is often a good idea, especially when loans are subsidized by the government to give you cheap costs of borrowing. If student loans were charging you 15% in interest however, you’d likely want to pay those off as fast as possible. Taking out a mortgage to afford a home is another common form of “good debt” that Canadians take on. It’s unlikely that anyone would be able to save up enough to buy a home in cash until they are already well into their career, making a mortgage a necessity if homeownership is a goal for you. As home values in Canada tend to appreciate over time, it’s often been a good financial move to take on a mortgage in order to get yourself on the property ladder early. You might also borrow money to purchase your home earlier in your career, knowing that your earnings are likely to increase over time. Another way to look at your mortgage, is that it gives you the opportunity to invest your money elsewhere rather than having all your capital tied up in your home.
Recommended reading: How your mortgage can help you retire early.
Borrowing backed by real estate is often the cheapest form of debt that’s available to most people so smart use of leverage will often involve a mortgage or a HELOC.
What debt should I pay off first?
With these factors in mind, we can start to classify some common forms of debt as generally good or bad.
Borrowing to help you reach financial, life, or investment goals, at the lowest interest rate you have available is generally considered good debt. Things like student loans, and your mortgage
Bad debt is borrowing to spend beyond your means or borrowing at a high interest rate.Things like credit card debt, personal lines of credit, and financing expensive purchases you can’t afford like a fancy new car.
If you have any “bad debt” or realize you’re using high interest borrowing when you have cheaper options available, it’s a good idea to pay it off as soon as possible. Most personal finance resources and guides will recommend paying down high interest debt as one of the first priorities in getting your finances in order, before investing. This is because it’s extremely unlikely you’re investments will return more than your high interest debt, so it’s unwise to invest that money while you still have that credit open. Think of paying off your debt to be an investment with a guaranteed return of the interest rate on the loan. If you have unpaid credit card debt or a personal line of credit at 10% or more, well, good luck trying to find a better investment than a risk-free 10%. When you’ve paid off high interest debt and are accessing the cheapest form of financing that you have available to you, that’s when you can start looking at smart ways to use debt to grow your wealth, but that doesn’t mean to take on as much cheap debt as possible (unless you know what you’re doing). We talk more about the risks of over-leveraging in this article: How to leverage real estate to grow your wealth (AKA The BRRR method).
What is the cheapest form of debt available?
Generally the cheapest forms of borrowing come from either government subsidized loans, or asset-backed loans. Governments subsidize loans to stimulate the economy and foster talent and innovation in the country. This means that student loans can be a cheap form of debt, and one that is used to invest in your future earnings. Business loans are similarly often subsidized by the government, so if you’re a small-business owner you likely have access to cheap loans and potentially grants.
After subsidized loans, the cheapest form of debt available to most Canadians is real-estate backed borrowing. The mortgage market is tightly regulated and lenders are willing to offer their lowest rates to borrowers when they have a home they can take as collateral. If you’re an existing homeowner with qualifying income from your job, a Home Equity Line of Credit is likely one of the lowest cost forms of borrowing you can access. Similarly your mortgage is likely a much lower interest rate than other forms of debt you have access to like a line of credit.
Using leverage can help grow your portfolio when you invest smartly
When debt is used to help finance investments with the expectation that they will return more than the cost of borrowing, this is called using leverage. Leverage can be a powerful tool that can help you grow your portfolio beyond what would otherwise be possible without borrowing. At the same time, it can add a significant element of risk to your portfolio depending on what you choose to invest in, and as we’ve already discussed over-leveraging can have major consequences.
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