What is the Difference Between Good Debt and Bad Debt?
A look at the different types of debt including, good debt, bad debt, and ugly debt.
Andre DeGagne is the Founder and Managing Director of Calgary based Dentro Financial
There are several different forms of debt that most of us will see in our lives including, mortgages, lines of credit, credit cards, vehicle loans, and even payday loans. However, it is not always easy to tell good debt from bad debt or even good debt from downright ugly debt. In this article, we will outline how to identify good debt, explain what debt is bad, and show you what debt to completely avoid. Debt does not have to be something that you fear. It is often a tool that can help you achieve your goals.
Before we jump into the different types of debt, it is important to take a quick look at how debt works. When you borrow money, you have to pay back not only the sum you borrow, known as the principle, but you also have to pay an additional sum known as interest. For example, if you borrow $10,000 for one year at 5.00% interest, you will have to pay back $10,500. In this example, the $10,000 is the principle, and the $500 is the interest. If we look at the same $10,000 over three years, it will cost you $11,500 instead of $10,500. Again, you pay $10,000 in principle but, this time, you pay $1,500 in interest because you had the loan for three years. As a quick note, interest rates are almost always presented to you in yearly terms, meaning that if you borrow money for three years at 5.00%, that is 5.00% per year.
The other concept required to understand the merits of different debt types is identifying if the interest portion of your loan is tax-deductible or not. If something is tax-deductible, it means that you can use that portion of your cost to reduce the amount of tax you pay. For example, when you have a mortgage on a rental property, the interest you pay can be used to reduce your income and subsequently your taxes. This means that if you collect $12,000 in rent payments and pay $3,000 in interest on the mortgage, you only have to pay taxes on $9,000 that year. There are several different tax rules and conditions that must be met for the interest on a loan to be tax-deductible, and it is recommended that you seek advice from a qualified legal or financial professional before assuming something is deductible.
Debt is not something that you always need to be scared of. In many cases, debt is necessary and is a great tool to help you get ahead. To create a simple formula there are three rules you should know. First, good debt can be identified as any debt that is used to move yourself forward. For example, borrowing money to start a business or taking out a mortgage to buy your first home. This house helps you move forward in life because it is deemed an appreciating asset, meaning that over time its value should increase. Also, as you pay down the value of your mortgage, you gain equity in the house. Over time this combination of paying the debt down and the increase in your home’s value will increase your net worth. Almost anytime you borrow money to increase your net worth, it can be considered good debt.
Second, good debt can have tax-deductible interest. If the cost of borrowing money helps to reduce your taxes then it improves the quality of your debt. Typical loans that have tax-deductible interest include government-backed student loans, a mortgage on a rental property, or an investment loan. In Canada, the mortgage and interest on the house you live in and any vacation properties you own is not tax-deductible.
The final indicator of good debt is that the loan is often cheaper than any other kind of debt. For example, a mortgage in Canada in November of 2021 is below 3.00%, while a federal student loan is currently prime (2.45%) plus 2.00%.[i] If the loan is currently below 5.50%, it is typically good debt. This threshold changes as interest rates rise and fall. If you have a loan that meets at least two of these three conditions, it can be considered good debt.
Now that you have a clear set of rules to help you identify good debt, nearly everything else can be considered bad debt. Bad debt is not necessarily detrimental to your financial situation and, for many people, will have to be used at some point. However, it should be used sparingly and eliminated as quickly as possible. We use this debt to buy things that were unplanned or unnecessary. Bad debt is often used to purchase things that we cannot afford. Some examples of bad debt include consumer loans, credit cards, department store loans, outstanding or unpaid taxes, and boat loans. No, your boat does not qualify as an appreciating asset and does not have tax-deductible interest. Taking a loan out on a boat is bad debt. Pay cash!
Simply, if you have to use a bad loan you can, but before you do, make sure you have a realistic plan to pay it back and ensure that the purchase is truly necessary. Using bad debt to finance unnecessary spending is a quick way to get yourself into trouble. Often, bad debt is also expensive, and without a plan, you will have a balance owing every month. For a normal credit card, the interest rate is 20.00%. If you owe $10,000 on that credit card, your minimum monthly payment will be about $170. If you only pay that minimum balance every month, it will take you nearly 20 years to pay it all back. Over that time, you will pay over $30,000 in interest to the credit card company. Yes, you just gave away $30,000! Make sure what you are buying with that card is worth the risk. A $200 pair of shoes you did not need can quickly become an $800 pair of shoes. Not to mention the associated stress that comes with knowing you have no plan to pay that money back.
Unfortunately, some loans have worse terms and put you in a worse position than bad debt. These loans are downright ugly and, if not managed quickly, can leave you financially paralyzed. An ugly loan creates a never-ending debt cycle. Every month you have to borrow money to pay back the debt you borrowed last month, and once you run out of items to pawn or one more appliance breaks, you do too. Your only way out of this cycle is by either making serious life changes or filing for bankruptcy. When you get into this situation, it feels like falling into quicksand. The harder you fight, the faster you sink. Unfortunately, at this point, the only people willing to lend you the money you need to survive are pawn shops and predatory payday loan companies. If you thought that the 20.00% credit card debt was expensive, keep in mind that some of these payday loans, when measured on an annual basis, can get as high as 46.90%.[ii] When you get to an interest rate like that, getting out is almost impossible.
If you get into a scenario where you have bad or ugly debt, you need to put a plan in place to get rid of those loans quickly. There are several strategies that you can use to tackle these bad and ugly debts including debt consolidation and snowballing payments. However, doing this on your own will be very hard and, in that case, you should seek help from a financial professional.
When managed properly, debt is not something that should keep you up at night. However, for many of us, it is our biggest source of financial stress. If understood and used responsibly, debt can help you buy a home, start a business or build your retirement. Good debt can be one of the most important tools you have to help you reach your goals, while bad debt will keep you trapped.
We hope that this article has helped demystify the different types of debt and that you now have some tools to help you evaluate the debt in your life.
We are helping people take control of their finances and reach their financial goals, one day at a time. You can learn more about Dentro Financial at dentrofinancial.com.