Good Debt, Bad Debt… What’s the Difference?
With credit so easily available it may seem harmless to borrow. But many Canadians have too much debt: At the end of September 2010, the average debt to disposable income reached an all time high of 148.1%. This represents a debt of almost $15,000 for every $10,000 in disposable income earned.
When it comes to borrowing money there’s good debt and bad debt – but what’s the difference?
“Good debt” is associated with the purchase of items or experiences that have ongoing or resale value. A home, for example, can be worth more when sold than bought. It can appreciate in value and therefore, can be considered an investment. So a mortgage can represent good debt.
Investing in your future or that of your children through education or skills upgrades usually brings rewards in career advancement and income. So, money borrowed to pay for education is also considered good debt.
Here are three other worthwhile reasons to borrow money:
1. Save for retirement: Borrowing money to top up a Registered Retirement Savings Plan (RRSP) will help reduce taxes, and savings can grow in value.
Tip: You’ll pay less interest if you pay back an RRSP loan within the year. If you take longer, one RRSP loan may start to pile up on top of another and you’ll lose the benefit gained from the initial reduction in taxes.
2. Handle an emergency: If the roof leaks, the pipes burst, or your car quits, you may have to borrow to pay surprise bills. However, it’s always better to put aside a little each month for emergencies.
Tip: Look for the lowest interest rate possible. Never take a high-interest loan, or use your credit card for large amounts. Pay back the loan quickly.
3. Pay off debt at a lower interest rate: ‘Consolidating’ high interest rate credit card debts into one lower cost loan can save money and allow debts to be paid off more quickly.
“Bad debt” is accumulated when you borrow or use credit to cover everyday expenses or to buy luxury items.
Rather than using credit to pay for things you don’t really need or for a life-style you can’t afford, save first. You may be surprised at how satisfying it is to finally own something you’ve saved for. And, you won’t be paying more than the sticker price because you won’t be paying interest on a loan.
Here are three reasons to avoid borrowing money:
1. Paying everyday expenses: You shouldn’t have to borrow to pay your monthly bills. If you do, you’re spending more than you’re making.
2. Covering optional spending: You’ll save money if you pay cash for luxury items like a new TV or a vacation. Borrowing makes the most sense when it’s used to buy something that can increase in value.
3. Borrowing when you can’t afford the payments: Do not allow debt to represent more than 35% to 40% of your gross income each month. This includes your mortgage, credit cards, and any other form of debt.
Remember: There are times when borrowing makes sense. But make sure you can afford the extra debt. Shop around for the best interest rate and don’t borrow more than you need, just because you can.
Check out six questions every borrower should ask, and learn more about managing debt.
The Investor Education Fund offers unbiased financial information to the general public via GetSmarterAboutMoney.ca. The not-for-profit organization was established by the Ontario Securities Commission (OSC), and is funded through OSC enforcement settlements.