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?