Most people do not know the difference between good debt and bad debt. Most do not even know there are different types of debt. One can be a powerful tool that can help you create a lifestyle of your dreams, whereas the other can set you back, hold you down and keep you stuck relying on your job a lot longer than you would have hoped for. Depending how you have grown up, you have probably had the mentality of either always having debt or being told to never have debt unless you must. If you must get it, make sure you pay it off as soon as you can and do not get any more debt.
This logic can be flawed as bad debt does nothing but burn a massive hole in your pocket as well as your spending habits because you are obligated to pay that money back. It will always keep you paying someone back and struggling to ever enjoy your money.
Let us have a closer look at which both debts are quickly with a few examples as to what they are and how they can either improve your situation or destroy it.
Good debt is viewed as borrowing money to buy an appreciating asset. This is used by the financially savvy to purchase investments that will in turn generate income producing assets. This comes in a few forms, with these being some of the most common:
- Business Investments
- Rental Property
- Private Lending
Small business investments are great because not only are you the boss, but you are also creating something for yourself that you are in turn selling to make a profit, either through a service or restaurant. You are no longer reliant on someone else for your paycheck as you can create one yourself. Every business starts small and with the right drive and motivation, the more problems you can solve the better your business will become. Amazon was not built in a day, but it easily solves hundreds of thousands of people’s problems every day.
If you are not interested running your own business, you can always invest in other companies through stocks. Stocks allow you to buy small parts of the company without requiring you to sit in on all the board meetings or working for the company. Companies that grow and solve more problems will see their share prices grow and become more valuable. If the company decides to in turn start giving out rewards to shareholders through dividend payments, this is a happy causality.
Warning: this can be good debt but can also lead to a bunch of debt if you are attempting to trade on margins (borrowing money you do not have to invest in a company). If you lose the money that was loaned out to you, not only do you have nothing to show for it, but you have now converted this over to a bad debt that now has recurring interest payments. I cannot stress this enough but taking out student loans or other types of loans to invest is extremely risky and can get you in financial trouble quickly.
Rental properties are another type of debt that, if implemented correctly, can boost your income and net worth through the four wealth builders of real estate. These four wealth builders are:
- Loan Pay Down
- Cash Flow
Loan pay down is when you are renting out a house and the mortgage is now being paid by your tenant, meaning you are no longer covering this expense out of your pocket. Cash flow is when the leftover cash after paying the mortgage, property taxes, HOA or Condo fees, insurance, utilities (if you are covering any of them) and reserves funds have been accounted for. The good news here is that some of these expenses are part of running the business and can be deducted for taxes. Therefore, you will not end up paying all of this out of pocket and you will more than likely be paying taxes only on your leftover cash flow. Finally, the last wealth generator of real estate is appreciation. This is when your property goes up in value over time.
There are a few compounding affects that this can have if you are a buy and hold investor. It is a win if your place appreciates in value. Your unit appreciating will allow you to slowly raise the rent a little bit each time, in turn providing you some extra cash flow. After a while, your equity will be growing from the loan pay down and from the appreciation in value of the house. This provides you with more options where you could refinance, pull out your initial investment (if it has appreciated enough) and purchase another property if you choose.
Private Lending can be a tool used to invest in all of the asset classes above but might not always be something that people are comfortable with or get around to. This type of lending tends to be a little more commonly associated with real estate ventures then the others but if you are further along your journey nd have a little extra cash, why not turn around and lend it out on good deals and trying to get a slightly higher return?
The reason this tend to be slightly more common in real estate ventures is if someone with a good record or with the knowledge of looking to expand their portfolio comes along and presents you an outstanding deal, you can choose to create a private loan with them that could let them purchase the property with your loan while agreeing to higher returns for the first 6 months to a year before they go and refinance and move the property to a conventional mortgage. While doing this, you are able to lend out your money for a slightly higher then normal return. Private loans tend to be in the ball park of 10-15% interest per year.
Warning: This is a creative venture that people can pursuit however there are many risks to pursuing this type of venture. Please consult with your financial advisor when considering these types of deals in the future.
This type of debt is the antithesis of financial freedom. Bad debt is more common and more widely and readily accessible than ever before. Everyone you talk to now has debt and it varies greatly in its type, shape and size. Bad debt is simply borrowing money to purchase a depreciating asset. Bad debt, while not always avoidable, can be avoided and managed better if a sufficient strategy is put in place ahead of time. Sometimes bad debt is necessary as it is the only solution to a particular problem or situation; when that is the case, it should be the #1 priority to be paid off. A few of the most popular kinds of bad debt are:
- Payday Loans
- Car/Boat Loans (Financing or Leasing)
- Student Loans
- Mortgages or Home Equity Lines of Credit (sort of)
- Credit Card Debt (generally ranging between 12 to 25% annual interest)
Very briefly, I have never heard of a good situation that started with “I got a payday loan because of X”. I understand that these services exist to help people out who are in a little bit of a pickle but please plan so that you can avoid them. They are special types of loans because they are paid back all at once instead of over time. This means if you borrowed money once, you would have to pay a fee to renew the loan and if you do this multiple times, you will owe more in the recurring fees than the original amount loaned. These are readily accessible through money marts, online or through banks and private loans. This is essentially robbing Peter to pay Paul because at the end of the day you still owe the money. If you do not overspend and you will be able to avoid this trap. If you build your emergency fund, you should be able to all but eliminate the use for this type of debt.
These types of debt are all bad in their own special ways. Things like cars and boats are depreciating assets (also known as liabilities) right from the second you drive off the dealer’s lot. Immediately they have lost approximately 30% of their value. These can quickly become double whammies when you are leasing them. Leasing vehicles has very few positives as not only are you renting a car for a certain number of years, but there are rules about how far you can drive per year, maintenance agreements that state you need to come to their dealership for servicing, amongst having to secure financing.
The only scenario where leasing a car could make sense is if you are a company’s executive or a contractor working in a new city for a few short years before moving back home. That is the only possible reason I can imagine that leasing a car is justifiable. If anyone has any other scenarios where leasing a car makes financial sense, please leave a comment!
Did you know that in the United States, the average person takes approximately 18 years to pay off their student loans? Here in Canada, it is a little closer to 10 years. I honestly believe that student loans have their place for some people. Here is my big issue with them: you are letting a 17- to 20-year-old decide what they want to do with their life, and they can charge it all to their future self to pay the debt later. Regardless of if they did not finish the degree, switched programs or switched schools entirely, they must pay back the money. That is a massive decision to leave to a young adult without knowing the greater consequences.
The average tuition in Canada for a post-secondary education is approximately $7,000 per year. With on-campus residence you are looking at closer to $18,000 a year. Multiply this number by four and you will get a rough estimate of what a 4-year degree costs on average in Canada. For someone living in locally, this number comes out to around $28,000 a year.
Letting an 18-year-old decide they are going to take on almost $30,000 of student loan debt with an average of 2.75% annual interest when the odds are, they have not even made anything close to that in their life to date is absolute madness. It is not anywhere as close to the absurd numbers that happens in the United States, but it is still a tough pill to swallow. That is a lot of debt to saddle someone with in order to get an education. If it took you the average 10 years to pay off that student loan you would have paid close to $34,500, [DD2] meaning you paid almost an entire extra year of tuition in interest. The world is changing and not all careers require a degree, but for lots of things you still require four years of post-secondary education to even get your foot in the door.
Mortgages are, in many cases, a natural type of debt that people have. I consider mortgages to be the lesser of bad debts here because at the end of the day, we need a place to live. The issue with mortgages comes when you start taking out a Home Equity Line of Credit (HELOC) against your house to go on vacation or buy a new car. As you pay down your mortgage you are gaining equity in your property. The more you pay down the quicker the equity grows. However, some people view this as their savings account and decide to apply for access to these funds and use them to purchase liabilities that will further destroy their financial positions in the forms of trips, boats, cars, etc.
Not only are you paying interest on money you previously paid down, but you are now using your own house as the collateral that this money is borrowed against. Messing around with a HELOC can get you into loads of trouble if you do not stay on top of it. It is much easier for most not to have them.
Credit card debt is easily the most common type of debt yet can be the most destructive in a multitude of ways. The reason is quite simple: credit cards give you the ability to get whatever you want now and pay for it later. It seems straight forward enough; the issue is when the outstanding balance isn’t paid in full and the interest starts to accrue. This starts as a small amount but can add up very quickly if you do not nip it in the bud. On top of the debt there, doing so will allow you to begin tanking your credit score. This can affect all types of debt because instead of getting good interest rates, you are having to pay premium points as you become a risk to anyone who loans money to you.
Figuring out the difference between good debt and bad debt will very quickly open your eyes to the world and show you how in control of your own life you are. We think that we have choices, but when you need to go to work to pay the bills the illusion of choice disappears, and we are only then working to pay off the bad debt.