Debt is often viewed in a negative light, evoking images of financial strain and endless payments. However, the reality is more nuanced: not all debt is inherently “bad”. In fact, when managed responsibly, certain types of debt can be a powerful tool for achieving your financial goals and building long-term wealth. Understanding the distinction between “good debt” and “bad debt” is crucial for your financial health.
What is good debt?
Good debt is typically associated with investments that are expected to grow in value over time or increase your earning potential. It can help you build long-term wealth, achieve significant personal goals, or provide a return on investment. These types of loans generally come with lower interest rates and more favourable repayment terms.
Common examples of good debt include:
Mortgages
A mortgage is often considered “king” of good debt because it’s an investment in a tangible asset—your home, which historically appreciates in value and helps you build equity. This can lead to a higher net worth over time. Additionally, mortgage interest can sometimes be tax-deductible.
Home Equity Lines of Credit (HELOCs) and Home Equity Loans
These are often considered good debt because they allow you to borrow against the equity in your home at relatively low interest rates. They can be used for beneficial purposes like home renovations that increase property value or consolidating high-interest debts.
Student loans
Investing in education through student loans can lead to valuable skills, improved career prospects, and higher earning potential, making it a wise use of debt. As of 2023, federal student loans have no interest and flexible repayment terms compared to other debt types.
Small business loans
These loans support the growth and success of new or expanding businesses, which can lead to increased profits and long-term financial stability. They often come with lower interest charges than other types of loans, making them more affordable for business owners.
Loans for investment properties or assets
Borrowing to acquire assets that generate income or appreciate in value can create wealth if the returns exceed the debt payments and associated costs.
Interest-free loans and refinanced debt
Loans with 0% interest or refinancing existing debt into a new loan with a lower interest rate can be good, as they save you money or make payments more manageable. Just be aware of how this new loan will impact your credit score.
What is bad debt?
Bad debt, conversely, is associated with purchases that quickly decrease in value (depreciate), things you don’t truly need, or debts that carry high interest rates. This type of debt can quickly get out of control, causing financial problems, straining your finances, and hindering your ability to reach financial goals. It generally doesn’t help increase your net worth or generate future income.
Common examples of bad debt include:
Credit card debt
This is one of the most common types of bad debt due to its typically high interest rates. Using credit cards for non-essential purchases or carrying a balance from month to month can make it difficult to pay off, leading to significant interest accumulation, late fees, and negative impacts on your credit score.
Payday loans
These short-term loans are notorious for their extremely high interest rates and fees, which can trap borrowers in a persistent cycle of debt. They are considered a very poor way to borrow money.
Loans for discretionary or luxury items
Borrowing for things like vacations, designer clothes, electronics, or other non-essential items that offer no financial return and often depreciate quickly is generally considered bad debt.
High-interest personal loans
While some personal loans can be good (e.g., for debt consolidation), they can be considered bad debt if used for luxury items or if they come with unusually high fees or interest rates, making them difficult to repay. Experts suggest that interest rates of 6% or higher might signal bad debt.
The gray area: When “good” debt turns “bad”
Not all debt fits neatly into “good” or “bad” categories, and even traditionally “good” debt can become problematic if not managed well.
Auto loans
These are often a “gray area”. While cars depreciate quickly, a reasonably priced vehicle might be necessary for commuting to work or transporting family, thus facilitating income earning. An auto loan can also help rebuild credit if managed responsibly. However, financing a luxury vehicle or taking on a loan with unfavourable terms can quickly turn it into bad debt.
Credit cards (Used Responsibly)
While carrying a balance makes credit card debt bad, using credit cards for convenience, rewards, or to build credit can be a smart financial move if the balance is paid in full each month.
The crucial factor is manageability. A student loan or mortgage, while typically good, can become bad debt if the payments become overwhelming relative to your income, forcing you to max out other credit or delay other financial goals. As financial experts caution, “Whatever you call it, anything you can’t pay is bad debt”.
How to tell good debt from bad debt: Key questions to ask
To assess whether a debt is likely good or bad, ask yourself:
Does this debt provide long-term value or increase my earning potential? Good debt should contribute to your financial future, like an investment in education or property. If it’s for something that depreciates or offers no financial return, it may be bad debt.
Can I afford the payments? Even good debt can become bad if you struggle to maintain payments, especially as bad debt typically carries higher interest rates that make payments unmanageable. A general guideline suggests allocating no more than 30% of your monthly budget to debt repayment.
Is this a need or a want? Borrowing for essentials or investments is often viewed positively, while borrowing for discretionary spending can lead to financial strain.
What are the terms of the loan? Favourable interest rates (typically under 6% for good debt) and flexible repayment terms are hallmarks of good debt. High interest rates (like 20% on credit cards) and fees often signal bad debt.
Managing debt wisely
Regardless of the type of debt, how you manage your finances determines your overall financial health. To avoid bad debt and effectively manage all your obligations:
Create a budget: Track your spending and income to ensure you can cover debt repayments and other financial obligations. This helps identify areas where you can save and avoid unnecessary borrowing.
Avoid over-borrowing: Only borrow what you can realistically afford to repay without putting undue strain on your finances. Just because a lender offers you a certain amount doesn’t mean you should take it all.
Build an emergency fund: Having savings for unexpected expenses prevents reliance on high-interest credit cards or payday loans during crises.
Improve your credit score: A good credit score can help you qualify for loans with more favourable terms and lower interest rates, saving you money in the long run.
Prioritize debt repayment: Consider strategies like the “debt avalanche” (paying off highest-interest debt first) or “debt snowball” (paying off smallest balances first).
Seek professional guidance: If you feel overwhelmed by debt, consider contacting a credit counselling professional or a Licensed Insolvency Trustee (LIT) for help with budgeting, debt repayment plans, or exploring options like debt consolidation, consumer proposals, or bankruptcy.
In conclusion, debt doesn’t have to be a burden. When approached strategically, it can be a valuable tool for building your financial future, helping you achieve significant goals like homeownership, education, or starting a business. By understanding the difference between good and bad debt and making informed borrowing decisions, you can move toward greater financial freedom.
