When you hear the word “debt” what images come to mind? I imagine someone sitting at their kitchen table with a mountain of bills piled high beside them. You might see something different. But the reality of hearing the word debt is, for many of us, something that brings up bad or stressful images. We’ve all been told, repeatedly, that debt needs to be avoided as we travel through life.
And yes, it’s true that most debt we come across in our daily lives can be negative or worrying for many of us. And it’s also true that many people struggle with debt pressures and often have great difficulty reaching their financial goals (such as paying down a credit card balance). The commonly-held belief is that once you get into debt, it’s very difficult to dig your way out of it.
So you may be surprised to discover that some types of debt are actually considered “good debt”. Here are a few examples of that “good debt” most of us need in our lives:
There was once a time when you could purchase a home in Canada without a massive mortgage. Unfortunately, those days are gone and most of us just can’t afford to buy a home, townhouse or condominium these days without qualifying for a mortgage. But unlike a credit card, which provides little but a debt balance owing once you use it, purchasing a home builds valuable equity and can save you substantially over the long run when compared to renting a home or apartment. For this reason, your mortgage debt could be considered to be good debt. The excess value in your home after subtracting any outstanding mortgages owing can also grow substantially over the years, allowing you to borrow further against it if your needs change, or sell the property and reap the financial rewards of that profit on the home.
However, it’s important to ensure you do not borrow more in the form of a mortgage than you can afford to repay to the lender. Before you take out your first mortgage, sit down and create a simple budget. Jot down your income at the top, then make a list of your monthly expenses, including mortgage payments, property taxes, utilities and other fixed expenses you know you’ll have each month of the year. In general, you should aim to avoid spending more than about 25-30% of your gross income (that’s your income before taxes) on housing costs. Although with the runaway housing market we have right now that might be tough to do.
Every parent hopes their children will attend a community college or university once they graduate from high school. But not every parent is able to afford to pay for that post-secondary education — tuition and housing costs for post-secondary students are out of reach for many families.
However, in general, the better education a young person receives, the greater their earning potential down the road. This isn’t always true but generally it’s a correct statement. In most cases, spending money on postsecondary education is an investment in that student’s future. If a debt is being taken out to potentially improve that student’s financial situation long-term, it can be considered a good debt.
Borrower beware, however, because unless post-graduation employment is located quickly those student loans can prove difficult to repay. Many graduates find themselves stuck with a large debt load when they graduate. The best strategy is to only take on as much student debt as you can handle and pay back and make sure you have some summertime employment each year so you can stash away a chunk of your income for future repayment of your debt.
Small Business Ownership
A business loan isn’t always considered good debt but borrowing money to start or expand a business to generate additional income can be a terrific idea if your business plan is solid and based on detailed research. After all, this money can be used to help you earn more money and grow your career. As long as your business plan makes sense, it might be a good idea to take out a business loan.
What Is Bad Debt?
Most bad debts are debts taken out to purchase items that will decline in value over time instead of increasing in value. For example, borrowing money to buy a new iPhone or some new clothes is typically considered bad debt. That iPhone could be very useful to you but it won’t increase in value and having a closet full of new clothes likely won’t help you earn any additional income. Therefore, these are debts that might not help you.
Of course, every situation is different and, for some people, a debt can be considered good while that same debt would be bad for someone else. Consider the situation of getting a car loan to purchase a new SUV. If you live in an area where getting around by public transit isn’t possible, borrowing money to buy that shiny new car may mean you’ll be able to get to work faster, earn more income, and ultimately improve your life. However, vehicles depreciate in value quite quickly (some experts claim a new vehicle depreciates by 25% the moment it’s driven off the lot) and borrowing too much to fund the loan for that car can hurt you financially. You may wish to consider purchasing a slightly-used car instead of a new one to save money (or save the funds up until you have enough for a larger down payment on the vehicle to reduce the monthly finance costs). .
With any loan, it’s important to make sure your budget can support the payments and that there is a long-term benefit to making the purchase. You also have to ensure you’re not taking on too much risk by taking on the debt. If there’s a good chance that you’ll have a tough time paying back the money you’re borrowing or if making the payments will put you in a stressful financial situation, it’s often best to say “no” to the purchase and the loan and come up with a different plan instead. Maybe take public transit for one more year until you can afford to buy that vehicle for less and with smaller monthly payments.
Debt should not be taken on lightly and you should always think about the impact of that debt on your life if you do decide to dip a toe into the debt pool.