Good Debt vs Bad Debt

Yes.. I mentioned the “D” word. Debt. Just letting that word roll off your tongue makes you feel like you have halitosis.

Well, get that tongue scraper and Listerine out, because as surprising(and somewhat crazy) as this may sound, there is such thing good debt AND bad debt.  And you might want to keep the good debt around longer (that means instead of paying off the good debt first, pay off the bad debt first) because there are some benefits to good debt unseen by the naked eye.

What can good debt do?  Good debt can help you decrease your taxes you owe to the government, and it's especially better for you if you're in the higher tax brackets.  If you're not taxed to the nines by the government, then good debt is not as fantastic as if you were in the 46% tax bracket.

What does bad debt do? Nothing. It just gives you a bad feeling and an ulcer.  It just sits there, grows interest while you tread the deep end trying to keep up with the payments.

Here are some examples of good debt.

  • Student loans from the provincial or federal government
  • Mortgage on an investment property
  • Lease payment on a car (max $800/month as per the CRA) that you use for work (by that I mean that you can claim capital cost allowance on your car- you need to HAVE to use your car for business)
  • Interest on any money you borrowed to generate income (can be for investment income too)— but note the key word GENERATE INCOME.  If you're borrowing at a rate of 7% and your stock market returns are only 5% then… that's not called generating income.

Here are a few examples of bad debt.

  • car payments if you only use your car to commute/ can't write your car off for tax purposes
  • principal residence mortgage (many people think this is good debt, but if it doesn't really do anything for you, then it's not good, really… and you can't bank on the home value to rise consistently)
  • credit card debt (always a bad debt, no ifs, ands, or buts!)- it's 18-21% interest– YUCK!

Okay here's an example of how it might look:

Let's say you just graduated school one year ago and have $10,000 in student loans to repay.  Let's also say that you netted a nice job as a fresh graduate making $50,000 (in the marginal tax rate of 29.70% in B.C.).  If you don't pay any tax because you don't have a high paying job yet, then ignore all this stuff about good debt, because good debt only gets you tax back.  If you don't pay tax, you don't need to get any tax back. You also have a car loan to pay off (about $500 a month), but because the $10,000 is such a big number and you want to get rid of your student loans, you try to pay that down first.

Scenario 1: Pay down student loan first by paying $1000 a month- let's hypothetically say the interest was $100 a month, and paying $500 to car payment.  Let's say the yearly interest paid hypothetically for the car loan was $200.

So the yearly interest paid for the student loan is $1200.  Because the interest is tax deductible, at a marginal rate of 29.6%, then you are really getting back: $1200x 29.70%= $356 > $200.

So you will get $355 back from the government.  If you pay the car loan off slower than the student loan, then you are slowly letting the government keep more of your money.
Scenario 2: Let's say you pay down your student loan slower,  only $800 a month, and you paid off your car faster.  If you have a yearly student loan interest of $1500, then $1500 x 29.70%= $446.  You'll have $100 more back from the government, and you'll pay less interest on your car because you are paying it off faster.  Win-win situation if you are in a higher tax bracket.

Both debts can be bad though, but one type (good debt) is less toxic to your personal finance than the other.  If you're going to have debt (and yes, we all do), then it better be good debt… unless of course (as I mentioned about and want to mention it again), you don't pay taxes OR you're paying really low taxes, then in which case, all sorts of debt isn't good.  Though the Canada Revenue Agency says you could defer claiming your student loan interest for the next five years.

Of course, debt is not good… PERIOD, but if we have to deal with it (which the majority of us do, unless we won the Lotto Max), then might as well figure out which one is somewhat advantageous.

Do you agree or disagree with my categorization of good debt and bad debt? Do you have any other ‘debts' that you would like to add to this list?

18 Comments

  1. Financial Samurai on July 19, 2010 at 6:53 am

    Interesting list, and I gotta disagree with “car lease payments” as being good debt even if you can write it off!

    I strongly believe that if you can’t pay cash for a car, you can’t afford it. The 1/10th rule of car buying in effect! Do the lease payments if it complies with the 1/10th rule, but generally, it doesn’t comply if one has car payments.

    Best,

    Sam



  2. Rebecca The Greeniac on July 19, 2010 at 12:37 pm

    I think you



  3. jesse on July 19, 2010 at 6:57 pm

    I think the term “good” and “bad” should really be used not just based on tax efficiency. A mortgage on a primary residence isn’t “bad” because you get capital gains free return at the end, unless you buy into the Smith maneuver scheme.

    A better question is why you would take on debt in the first place. If it’s because you can eke a positive return by doing so, even if it’s not tax efficient, I think it’s worth it. It just so happens the government generally agrees with this and offers deductions to foster this behaviour.



  4. Big Cajun Man on July 19, 2010 at 6:58 pm

    “…Of course, debt is not good



  5. Dividend Lover on July 19, 2010 at 7:00 pm

    I always say normalize Interest on debt according to tax advantages then prioritize for borrowing / repayment according to cost.

    It does not matter the source or purpose of the debt, all that matters in the after tax interest rate.

    so for example, if there is a 0% financing deal when you are buying a car, or a don



  6. young on July 19, 2010 at 8:42 pm

    @Financial Samurai- I remember reading your post on the 1/10th rule a few months ago =) Yeah, some people (realtors etc. and entrepreneurs) I believe get leased cars anyways because they are in the higher tax brackets so they can write off taxes, even though it is very apparent they can pay it off in a lump sum. I agree myself that one should not get a car unless they can pay it off =) I don’t like the idea of adding another payment ontop of the mortgage, that’s like begging to live paycheque to paycheque.



  7. young on July 19, 2010 at 8:42 pm

    @Rebecca- I agree it’s like a catch-22 =) Do you want to get more tax back, or do you want to pay less interest? That is the question. =P



  8. young on July 19, 2010 at 8:44 pm

    @jesse- Thanks for visiting. Yes I love the idea of free capital gains on a primary residence, but that is provided that you sell the house/home for a profit (please see previous posts on the housing market) =P That would definitely be the ideal situation. Thanks for your input, jesse.



  9. young on July 19, 2010 at 8:45 pm

    @Big Cajun- Hahaha, I definitely added that to the post because I knew I would likely start a riot =) Thanks for visiting Big Cajun!



  10. young on July 19, 2010 at 8:48 pm

    @Dividend Lover- thanks for sharing. That’s exactly what my dad does… he can pay things off, but would rather finance with low interest like 0.9% or 0% for a few months to reap the tax deductions, as well as use that capital for other investments. I like your poem- it summarizes good debt and bad debt in a few sentences.



  11. Financial Cents on July 20, 2010 at 4:56 am

    Hey Y&T – I don’t know about the principal residence. I would disagree with you there. Yes, a mortgage isn’t great, but everyone needs a roof over their heads and as long as you aren’t counting on your home to rise 5-10% every year in value (unless you’re in Vancouver :), I think a home is considered good debt to have.

    Why?

    Over time, a home will appreciate in value; maybe not by leaps and bounds – but it will. An asset that will appreciate is considered an investment (and debt to hold it is considered good), an asset that will not appreciate is a liabilitiy (and debt to hold it is bad).

    I guess if we could all avoid debt, you wouldn’t be writing this article and I wouldn’t be commenting! 🙂



  12. Little House on July 20, 2010 at 9:09 am

    I think your overall statement is correct, all debt is bad, period. However, if you do have debt, then categorizing what’s less toxic is a good way to decide what to pay off first. I agree that student loan debt is less toxic and car loan debt is more toxic. So paying the car loan off first makes sense. Also, I think that credit bureaus calculate student loan debt differently than revolving debt when calculating a credit score. I haven’t been able to find detailed information on this one, but based on my credit score, they must be factoring in my student loan debt differently. I also agree with FS, leasing a car is silly, even if you can write it off.



  13. Barb Friedberg on July 20, 2010 at 5:16 pm

    Hi- Like the article so much it’s going in my round up tomorrow.. But, I don’t agree with the idea that a home mortgage is “bad” debt. I don’t know if it’s true in Canada, but in the US you can deduct the interest on the loan on your tax return. Nevertheless, I wouldn’t recommend getting a loan that’s too big! Regards, Barb



  14. Mich @BeatingTheIndex on July 20, 2010 at 7:27 pm

    Y&T,

    There should be a worst debt category for credit cards and loan sharks exclusively!

    Good debt can potentially be a loan taken in a low interest rate environment for investment purposes. I guess, the end result would decide in which category to place that debt =)

    Cheers!



  15. young on July 20, 2010 at 7:37 pm

    @Financial Cents- Thanks for your comment. I do agree that a principle residence can be good debt, but I find that generally a lot of investors do not consider it so, I suppose because a) it doesn’t churn out cash flow and b) it might not necessarily increase in value. I personally would rather categorize a principle as good debt (hey you know me, I’m planning to buy a place here in Vancouver!) but I think I would have gotten a bigger backlash if I categorized it as that. =P

    @Little House- that’s a good way to put it- “less toxic”, thanks! Good point re: credit bureau calculations too!

    @Barb Friedberg- Yay! thanks for including it in your round up. Really? you can deduct the interest in the states? I need to get my butt down there lol. You can only do that here in Canada if you are using a portion of your home to make money (like rent out the basement suite).

    @Mich- Yes, Good Debt Bad Debt Worse Debt! Yeah, credit cards are just ridiculously bad for you (if you don’t pay them off). Thanks for visiting!



  16. Dolla Thug on August 2, 2010 at 7:45 pm

    I definitely understand your argument, but I’m just so anti-debt that the idea of “good debt” just doesn’t convince me. I understand that credit card debt is “worse” debt than student loan debt, but I’m currently in the process of paying off my student loan debt because it’s DEBT. It’s an obligation that I OWE to someone and I can’t WAIT to pay it all off (both federal and private). One day……



  17. young on August 2, 2010 at 8:14 pm

    @Dolla Thug- honey, I’m super anti-debt too, but I think it’s a necessary evil (e.g. mortgage debt) unless you win the lottery or something, unfortunately. You’ll pay off your student loan debt in no time, I’m sure. Personal Finance Bloggers are pretty good with their money =) Tracking your net worth or your progress is a great way to do it (and post it online) because it keeps you accountable. That’s what I’m doing and I think it works. =P



  18. susan on July 29, 2013 at 12:48 am

    In your article, good debit vs bad, you mentioned CCA on a car you don’t own. If I am not mistaken, you cannot depreciate a vehicle you don’t own. But, you can write off the lease payments up to a limit? I claim 2 vehicles in my business for the CCA , because I fully own them. Let me know if I have missed something, thanks.



Leave a Comment





Pin
Tweet
Share
Share
Email
+1