Good Debt vs. Bad Debt: What's The Difference?

The goal of living debt free is certainly an admirable one and something we support wholeheartedly. However, its not always reasonable for everyone to pay cash for life's most expensive purchase — such as buying a home, purchasing a vehicle or paying for post-secondary education.

While this can feel disheartening, there is some good news ahead. It is possible to take on certain kinds of debt without compromising a healthy financial future. The key is understanding the difference between a good debt versus a bad one and how to manage your finances to ensure you're in a better position when you've paid the debt off than you were when you started.

Good Debt

In short, a "good" debt offers the borrower an opportunity to increase their net worth after repaying the principal balance and interest costs.

Some examples include:

Real Estate – Provided the market increases and allows you to earn a return on investment, purchasing a home and paying down the mortgage will increase your net worth over time. Mortgages also tend to have a lower interest rate compared to other types of loans.

Student Loans – Furthering your education may help you obtain a more stable career with higher earning potential than those who do not. Student loans are generally low-interest and offer different repayment options to suit your situation following the completion of your studies.

Investment Loans – The principle here is to borrow money so you can make money. Done successfully, it can offer an accelerated means to increase your net worth while at the same time allowing you to pay off the debt more quickly.

Bad Debt

Conversely, "bad" debt is anything that increases the cost to the debtor above what they initially paid for a product or service. Factors to consider when determining if a debt is bad include the associated interest costs and whether the purchase itself is likely depreciate over time.

Some examples include:

Credit Card Debt – Credit cards tend to have prohibitively high interest rates — often between 19.99 and 30 percent per month. Any purchase you make with your credit card that you cannot afford to repay at the end of the month will cost you significantly more than you paid, and often more than it is worth.

Payday Loans – Nearly impossible to resolve on one's own, payday loans are arguably the worst kind of debt available. They have excessively high interest costs, built-in fees and an ultra-short-term repayment structure. These debts are a revolving door designed to keep you coming back repeatedly to cover the shortfall of the previous one.

Debt is Debt

Nothing is ever black and white. There are risks involved with any debt, good or bad. The most important factor to consider is whether you can afford the payments and have a clear plan to pay it off.  

Remember, even good debt can be bad if the cost is more than you can afford right now. A good debt also offers no guarantee things will go as planned. The housing market could decline, making your house worth less than what you paid for it. You may earn a post-secondary degree only to learn there is little demand for your chosen profession. And a bullish stock market could turn at any time, limiting or even reversing your returns.

Alternatively, sometimes bad debts can be preferable — especially in cases where they help you escape an even more unmanageable debt situation. Consolidation loans are a good example.

In many cases there is no definitive answer to whether a debt is good or bad. If you need a vehicle to get to work, you may have to juggle the costs and benefits to taking out a car loan — knowing you need to earn a paycheque, but also that the value of your purchase will rapidly depreciate.

Choosing the Right Debt 

Beyond good and bad is the question of whether any debt is right for you. The easiest way to answer that question is by determining whether your desired purchase is a need or a want. If you need the item but can't afford to pay for it all at once, debt may be necessary. If it's a want, on the other hand, consider alternative ways to make the purchase — such as saving for it over time — that won't adversely impact your financial future.

Free Confidential Consultation

Good debt or bad, if you've found yourself in a situation where you're struggling to make ends meet, a Licensed Insolvency Trustee can help. During a Free Confidential Consultation, they will review your financial situation to determine whether a Life-Changing Debt Situation may be right for you. They'll help you understand your options and decide your best path to a financial fresh start.