The Difference Between Good and Bad Debts and How Each Affects Your Financial Health
The word “debt” often has a negative connotation and is thought of as something bad that you should avoid if possible. But that isn’t always the case. Contrary to popular belief, there are good debts that you shouldn’t be afraid of. But at the same time, there are also several “bad” debts that you should be wary of.
So, how do you know the difference between the two? And what actually qualifies as good debt or bad debt?
Keep reading to learn more about the distinction between good debts and bad debts and how they affect your financial health.
What Is the Difference Between Good Debt and Bad Debt?
The line between “good” and “bad” debt is not always 100% clear. However, generally speaking, good debts are those that are considered an investment that will help you either earn money in the future or grow your assets.
Bad debt, is debt with high-interest rates that is incurred to purchase things – stuff – that has no value, or quickly depreciates in value, and can negatively impact your overall financial/credit health.
Examples of Good Debt
Here are examples of debts that are usually placed in the “good” debt column.
A mortgage is considered good debt because it allows you to purchase a home and build equity.
Plus, depending on where you live, real estate values tend to grow over time, increasing your chances of having a return on your investment.
Mortgages usually have a long payment term of 25 to 30 years. This is very positive, as it allows payments and interest rates to remain relatively low which frees up your cashflow.
Home Equity Line of Credit
A Home Equity Line of Credit (HELOC) is a form of revolving credit secured against the equity in your home. The amount that can be borrowed varies; however, most banks will lend up to 65 per cent of a home’s value. Some banks will lend a greater percentage of value.
HELOC’s often have much lower interest rates than other debts, and are typically used for expenditures that add value, such as:
- Home renovations
- Post-secondary education
- Consolidating debts
- Emergency funds
This is what classifies them as “good debt.”
However, be careful when taking out a HELOC, as it can easily cross over into the “bad” debt category if used for unnecessary expenses such as a vacation, expensive new vehicle, or other luxury purchases.
It’s also important to keep in mind that banks can raise the interest rate of a HELOC or demand payment at any time.
Most recent graduates faced with paying down their student debts would likely not consider this type of loan a “good” debt. However, because the loan is used to pay for a post-secondary education that will allow you to earn you a higher salary over time, this is in fact considered one of the better types of debt you can have.
Plus, similar to a mortgage, government student loans have much lower interest rates than most other debts. Student loans also often have more flexible repayment plans. The federal and provincial student loan offices will work with students who graduated or quit school to make payment arrangements, including deferring payments and, in some case, writing off some of the principal.
Small Business Loan
For some, borrowing money to start your own business can be the best type of debt, because it can lead to a good income if your business takes off.
Similar to a student loan, what classifies a small business loan as good debt is that the money is being used to support your personal and financial growth and to invest in your future. Plus, banks lend money through federal government loan programs for small businesses at lower interest rates than the bank would lend its own money.
Examples of Bad Debt
Here are types of debt that are generally considered bad to have.
Most credit cards carry a high-interest rate, making them difficult to pay off in a reasonable amount of time, if more than a very modest amount has been borrowed.
Another reason credit card debt is considered a bad debt is because it is often used to purchase items that depreciate in value, which end up costing you significantly more than what you initially paid due to high-interest rates and very lengthy amortization periods. If you read the back of your credit card statement, you will note that if only a minimum payment is made each month, it will take you 10, 20, 30 years or more to pay the balance off. And this assumes interest rates do not go up!
For example, if you buy a brand-new smartphone for $700, use your credit card that has an interest rate of 19%, and only make minimum monthly payments of around $17.50, it will take you over ten years to pay off that phone.
Plus, you’ll have accumulated more than $750 in interest charges, making that $700 phone cost you more than double its original cost!
Unlike a home that typically only grows in value over time, all cars depreciate in value the second you drive them off the lot, meaning you will never get a return on your investment. For this reason, an automobile loan is usually considered a bad debt.
Additionally, many auto loans have high-interest rates, even further establishing them as a “bad” debt.
High-Interest Loans/Payday Loans
The worst of the worst of bad debts is the “payday loan,” also known as a short-term high-interest loan.
These are usually small loans – under $500 – that are obtained in a pinch when you need cash fast and cannot wait until your next paycheck. The catch is that they come with astronomically high-interest rates and must be repaid by your next payday. And if you are unable to repay the loan plus interest, penalties will be imposed, and your debt will continue to accumulate massive amounts of interest.
Depending on which province you live in, interest rates can reach as high as 650%, and costs can range anywhere from $10 to $30 for every $100 borrowed, making payday loans one of the most expensive debts you can have.
Simply put, this kind of debt should be avoided at all costs.
How to Overcome Bad Debt
If you are struggling to overcome a large amount of bad debt, it’s time to take control of your financial health and speak with a Licensed Insolvency Trustee (LIT) about your debt relief options. Some of these options can include:
A consumer proposal is a debt relief solution that enables you to negotiate a settlement agreement with your unsecured creditors.
Administered by a LIT, a consumer proposal will allow you to partially repay your unsecured debt, with no interest, over a specified period of time, with the remaining balance to be forgiven by your creditors. A consumer proposal must be completed within 5 years and payments are usually made monthly.
Debt Management Plan
A debt management plan is when a credit counselling agency (not to be confused with a Licensed Insolvency Trustee) combines all your debts and negotiates a settlement with your creditors.
The end result is often a simplified payment plan for your debts and some relief from interest costs.
A downside to this is that you will end up paying your creditors much more than you would with a consumer proposal, which reduces both principal and interest. Also keep in mind that the agencies that oversee debt management plans are not regulated nor subject to training requirements or professional ethics. They may or may not be insured. Not all banks will work with credit counsellors, and their services are typically limited to credit card debt and some bank loans.
Debt consolidation allows you to combine all, or most of your debts, into one monthly payment, with possibly a lower interest rate.
The main benefit of this is that you can focus on just repaying one single lender rather than making several payments a month towards various debts that each have their own high-interest rates.
If you find yourself overwhelmed with large amounts of “bad” debt and are feeling like there is no way out, seek guidance with a LIT who will walk you through all of your debt relief options so you can focus on getting yourself back on the road towards improving your financial health.
Baker Tilly Ottawa Ltd. is a Licensed Insolvency Trustee. Its professionals have assisted thousands of individuals successfully resolve their debt crises and overcome financial turmoil since 2002. Its passion – its mission – is your health and well-being!