Decoding debt: The difference between bad and good

Debt is a common part of life –– despite it’s also complicated because not all debt is created equal. Some debts can help you achieve your financial goals. Other debts can hold you down and limit your opportunities.

Weighing whether your debt is good or bad is in how you manage and understand it.

What is good debt?

Good debts are those you accumulate to invest in your future. It helps you increase your income, build your wealth, and improve your quality of life. They typically have lower interest rates along a longer repayment term and leave you better off than if you hadn’t taken the debt on.

Categories of good debt are:

Student loans –– Education can help further your career and increase your earning potential. And student loans often come with lower interest rates.

Mortgages –– Real Estate is seen as an investment and a large one at that. Because homes, or any real estate in general often appreciate in value, most people increase their net worth as they pay down their mortgage.

Business loans –– The primary reason for business loans is to borrow money so you can make money. These loans are to aid you in starting or expanding your business, which leads to generating income which you can re-invest in the business to accelerate its growth.

What is bad debt?

Bad debt is the debt you take on to pay for things that don’t increase in value or improve your situation. It’s debt that hurts your financial wellness, eats through your savings, and declines your quality of life.

Categories of bad debt are:

Credit card debt –– While there are instances where credit card debt can improve your credit rating when managed properly, it’s also easy to overspend and over rely on credit cards for everyday expenses, impulse purchases, and emergencies.

The interest rates on credit cards are also typically quite high, varying from 19.99 percent and 30 percent. According to the Bank of Canada as May 2024, the average interest rate on outstanding credit card debt was 20.5 percent. If you don’t pay your balance off by the end of the month, this can make it extremely difficult to keep credit card debt under control.

Payday loans –– These short-term loans are widely considered the most harmful type of debt as they’re designed to keep you coming back every few weeks. They work by using your paycheque as collateral and often have an annual interest rate (APR) of 400 percent or more. They also can include built-in fees and ultra-short-term repayment structures.

Once you’ve started down the path of payday loans, it’s nearly impossible to recover without the help of a Bankruptcy or Consumer Proposal.

Car loans –– Most cars lose about 10 percent of their purchase price the moment you drive them off the lot and keep depreciating the longer you own them (about 10 percent the first year and 15 to 25 percent each year that). At the same time, the amount you’ll pay for the car continues to go up if you take out a loan due to the interest payments.

If you take out a car loan on a $50,000 vehicle, you can expect to spend about $60,000 over a typical seven-year loan term, not counting maintenance and fuel. Yet, when it comes time to sell that car, it will only be worth $14,425, leaving you about $45,575 poorer than when you started.

Car loans can also be deceptive, designed to lend you more money that you need, giving you the perception you can afford a more expensive vehicle.

Effective ways to manage your debt

To understand how debt can hurt or help you consider whether you can afford the payments and create a clear plan to pay it off. Debt can feel dauting, but by taking a step back and going back to basics there’s a path to managing your debt wisely.

Make a budget –– A budget helps you track your income and expenses and can help you determine if debt is affordable and worthwhile. A good tip is to keep your payments below 35 percent of your gross income (i.e., before taxes and expenses).

Prioritize debt –– Pay down high-interest rate debts first, followed by your short-term loans or any debts that negatively impact your credit score the most. If you have multiple high-interest rate debts like credit cards, consider paying off the ones with the lowest balance first to get some quick wins and build your confidence.

Consolidating debt –– If you have multiple debts with high interest rates, you may benefit from consolidating them into one loan with a lower interest rate and a longer term. This can help you save money on interest and simplify your payments. You can use a personal loan, a balance transfer card, or a home equity loan to consolidate your debt. Consider speaking with a professional before consolidating to weigh your options and ensure the loan is right for you.

Avoiding new debt –– At the end of the day, the best way to prevent bad debt is to avoid taking on new debt. Is your purchase necessary? Can you afford to pay it off in a timely fashion? Will the loan lead to positive return or investment in the future? If the answer to those questions is no, you may want to reconsider taking on debt to finance the purchase.

How we can help

Debt can be a friend or a foe, depending on how you use it. By understanding the difference between good debt and bad debt, and by following some simple steps to manage your debt wisely, you can improve your financial health and achieve your goals.

If you find yourself in a situation where debt is negatively impacting you, meet with one of our Licensed Insolvency Trustees who can help you understand your options. During the Free Consultation, they can review your current financial situation and offer you insight on how to choose the right course of action for you.