But don’t be too quick to demonize debt. Believe it or not, there is such a thing as good debt. To keep your personal finances in order, it’s vital to understand the difference between good and bad debt.
Good Debt vs. Bad Debt
Generally speaking, the main difference between good and bad debt is how debt affects your personal bottom line. If the debt is going to act like an investment and increase your net worth or if it’s going to have reliable future value, it would be considered good debt. If, however, you incur debt for items that will decrease your net worth or lose significant value over time, that debt would be considered bad. Examples of each type of debt that follows here can make the distinction easier to understand.
What Is Considered Good Debt?
A mortgage is a positive example of debt because owning a home boosts your net worth. Property is an asset that usually grows in value over the years. Likewise, as long as you make regular payments, home equity loans and lines of credit can fall into the good debt category. These kinds of loans tend to be used by people to pay for renovations that will improve the value of their home or be used as a consolidation loan (more about this below) to pay down high-interest debt from other sources. Here are some examples:
- Because mortgages, home equity loans and lines of credit tend to have lower interest rates than other kinds of loans, repayment is much more manageable, further underscoring their categorization as good debt.
- Taking out a student or personal loan for tuition to pursue higher education or improve your skills and job prospects is also considered good debt. Education and improving skills are investments in your future that should help you secure a higher paying job, and thus, increase your overall net worth.
- When used responsibly, borrowing money to invest an RRSP or TFSA for retirement can also be good debt, depending on your financial circumstances. For instance, with COVID-19, borrowing to invest after a market crash can be a smart strategy for kickstarting your retirement savings.
- A debt consolidation loan could be considered good debt, depending on the circumstances. This is when you take out a single, larger loan to pay off multiple smaller loans with higher interest. It’s “good” because you’re paying much lower interest than a credit card (which usually charge 19% or higher). For instance, Loan Connect offers interest rates starting as low as 4.60% and Loans Canada offers interest rates starting at 5.15%. That could save you a bundle in interest charges.
What Is Considered Bad Debt?
Bad debt is debt incurred for items that don’t add to your net worth and have no long-term value. Credit card debt is a major cause of bad debt in Canada. Most of the items we charge to credit cards – like clothing, restaurant meals and electronics – have no long-term value. And no, even feel-good items like vacations don’t qualify as smart debt. Sadly, good memories don’t trump bad debt. Let’s look at some scenarios:
Car loans fall into a grey area and cause disagreement between financial experts when it comes to classification as a good or bad debt. On one hand, a car loan seems like bad debt because cars depreciate rapidly and incur many costs, like gas, insurance and maintenance. On the other hand, if you need a car to get to a higher-paying job or if you have a business where having a vehicle could significantly increase your business revenue opportunities, then a car loan could be classified as good debt. The possibility of writing off some of your car expenses against your income would nudge it further into the good debt category. The bottom line? Look for the best car loan rates in Canada in order to minimize the interest charges that you pay over the long-term. For instance, we're big fans of Loan Connect because interest rates start at 4.60% and you can get approved in as little as 5 minutes.
Car loans fall into a grey area and cause disagreement between financial experts when it comes to classification as a good or bad debt. On one hand, a car loan seems like bad debt because cars depreciate rapidly and incur many costs, like gas, insurance and maintenance. On the other hand, if you need a car to get to a higher-paying job or if you have a business where having a vehicle could significantly increase your business revenue opportunities, then a car loan could be classified as good debt. The possibility of writing off some of your car expenses against your income would nudge it further into the good debt category.
The bottom line? Look for the best car loan rates in Canada in order to minimize the interest charges that you pay over the long-term. For instance, we're big fans of Loan Connect because interest rates start at 4.60% and you can get approved in as little as 5 minutes.
What Is A Good Debt To Income Ratio?
If you’re still finding it difficult to get a clear picture of what constitutes good or bad debt, a straightforward solution is to figure out your debt-to-income ratio. To figure out your “DTI,” you begin by adding up all your monthly debt (such as mortgage payments, home and auto insurance costs, credit card payments, etc.). Next you add up your monthly income (like your pay cheque and any other sources of income). Then divide your total monthly debt by your gross monthly income and then multiply the total by 100 to get the number as a percentage.
For example, if you make $5,000 a month and your debts add up to $2,500, your DTI is 50%. Generally, a DTI of 43% or over is not good. The ideal debt-to-income ratio is 36% and under.
When Is Debt Consolidation A Good Idea?
Debt consolidation is when a person with a lot of high-interest debt from multiple sources (like credit cards and personal loans) combines them into one larger but more manageable debt. As mentioned previously, under the right circumstances, getting a debt consolidation loan could fall under the category of good debt if you get a lower interest rate and can pay down your other outstanding loans. Consolidation loans would be viewed as good debt if they put you in a better position than continuing to pay back multiple creditors.
It’s important to note that there are various types of debt consolidation available. Getting the best debt consolidation options will depend on factors like whether or not you have a good credit rating total debt load and assets. Start by looking at The Best Personal Loan Interest Rates, but Loans Canada is a reputable place to start. It functions as a search platform to find the best personal loan to suit your needs and offers loans up to $50,000 and interest rates starting at 5.15%.
In general, if you have a history of bad credit, you may want to avoid pursuing a debt consolidation option because you usually get a favourable interest rate only if you have a good credit rating. If you do have bad credit, and really need a loan, you may want to check out these top bad credit lenders to see if a consolidation loan still makes sense for you. Another option is to get a guarantor who is willing to assume responsibility for your loan if you default on payments. Companies like LendingMate exclusively offer guarantor loans, but they should be considered a last resort because of their higher interest rates.
Fairstone is also a good option: it offers both secured and unsecured loans at lower interest rates than other non-bank lenders, and you can get an instant quote online. If approved, the funds can be deposited into your account in as little as 24 hours. Fairstone qualifies more people with fair to good credit ratings than banks.
Should You Consolidate Credit Card Debt?
With their high-interest rates and deceptively small monthly minimum payments, it’s no wonder that credit cards can easily lead to an out of control debt load. It’s not surprising that one of the most common reasons people opt for a consolidation loan is to better handle their credit card debt. There are two ways to consolidate this type of debt: by using a credit card with a balance transfer promo or getting a low-interest credit card.
With one of the best balance transfer credit cards in Canada, you can move debt from other credit cards (usually for a fee of anywhere from 1% to 3% on average) to a new credit card offering a temporary low- or no-interest period. As long as you pay off the balance before the promotional period ends, you could save hundreds, if not thousands, of dollars on interest. Learn more about How to Transfer a Credit Card Balance Wisely.
A low-interest credit card offers a reasonable interest rate as a standard feature, rather than just as a promotional bonus. While not as beneficial as having a zero-interest period, these cards give cardholders more time to pay down debt while taking advantage of a more reasonable interest rate. Note that some of these cards feature annual fees, but the amount you’ll save on interest should easily offset the fee.
The Final Word
Having just gone over the difference between good and bad debt, I do want to add an important caveat. Even good debt is not good if you can’t make payments comfortably. A mortgage is only good debt if you are financially able to make your mortgage payments, as well as keep up with the maintenance and other costs of owning a home. The same can be said for getting a loan to pursue a post-secondary degree. Higher education is no longer a guaranteed path to a lucrative and secure career, so choose wisely.
In the end, assessing debt comes down to a realistic appraisal of whether or not you can handle payments and a clear understanding of whether an item will likely add to your net worth and/or increase in value in the future. If you have questions about your financial future, think about making a financial plan and finding ways to pay down your debt faster.