Good debt vs. bad debt: Know the difference
Credit to Author: Shalini Dharna| Date: Wed, 27 Sep 2023 02:01:37 +0000
As children we have been told to avoid debt, save money, and invest wisely. But the reality is that not all debt is bad! Not all debt is created equal and sometimes the risk with debt is worth it for the potential return on investment. So, what is good vs. bad debt?
In short, bad debt has no real return on investment. This category tends to be your everyday consumer debt – while that designer bag may provide an ego boost but declines in value.
Good debt, on the other hand, has a potential return on investment and in some cases provides a tax benefit too! Let’s dive into this a little more.
1. Student loans. Taking out a loan for furthering your education is almost a no brainer. It advances your career potential and, in turn, your earning potential – so the return on investment is almost guaranteed. If the loan is received under either the Canada Student Loans Act, the Canada Student Financial Assistance Act or the Apprentice Loans Act then the interest is also tax deductible. WIN-WIN!
2. Business loans. Whether you are borrowing money to start your own business, or investing in someone else’s business, the interest on the debt is tax deductible. As an investor in the business, you also hope to yield a return on your investment. This can be in the form of dividends or charging a higher interest rate to the lender.
3. Investment loans. When you borrow money to invest in the market it’s called leveraging. With this, the idea is that by having more invested, you get a potentially higher return. Of course, the rate of return needs to be higher than the rate of borrowing to be effective! This is why this particular investment strategy is not for the risk averse investor. The good news though is that the interest on investment loans is also tax deductible!
The above are what I consider good debts because not only do you get a return on investment financially (or so we hope), but you get a tax deduction too!
There are two loans which, while they do not generate a tax deduction, are necessary to function in society.
1. Mortgage loan. As of right now the gain on your principal residence is the only thing not taxed. Investing in a home can yield a great return on investment as most properties do appreciate in value over time. So, while in Canada there’s no real tax benefit to owning a home, I still consider this a good debt overall to have.
2. Car loan. Cars do not appreciate in value, nor do they offer you any tax write-offs UNLESS you are driving your vehicle as an entrepreneur or sales person. Yet depending on where you live, a car is necessary to help you get to work, run errands and enjoy life. So, for the convenience of having a car I consider a car loan as good debt.
So, what is bad debt then?
Bad debt usually refers to borrowing for items that do not appreciate in value or have a long-term benefit. It typically stems from consumer purchases of non-essential items. Typical examples are credit card debt, or lines of credit/loans used to purchase luxury items like vacations, electronics, or even short-term loans to cover cash flow gaps. These loans come with high interest rates make it difficult to pay off debt, leading to financial stress. So, while you may have enjoyed that vacation, the cost of it ends up being considerably higher when you factor in the interest accumulated to pay it off.
The other harsh reality is, in the current economic conditions with inflation running rampant, many families are racking up consumer debt over essential items too. With prices increasing at a rate higher than salaries, consumer debt for some has become a necessary cost of living. It is important to manage all debts responsibly to avoid adding financial stress to your already stressful day-to-day life.
Here are three tips to help you manage your debt.
1. Make a budget: Budgeting is not meant to be restrictive but to help you plan for your goals. Make a budget that fits your cash flow and stick to it even if it means delaying purchases.
2. Minimize credit usage. Cash can be your best friend when you’re living on a tight budget. By taking out as much as you have allocated, you avoid over-purchasing. Another option is to use your credit card, but immediately pay it off. I prefer this solution because you can get credit card points and build your credit score.
3. Pay more than the minimum. If possible, on your existing debt, try to pay off more than the minimum to reduce accumulated interest charges. It is also important to save while paying down debt, so you avoid dipping back into credit when an expense comes up!
If you are struggling with debt, consider seeking advice from a professional who can tailor guidance to your individual situation.
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