In a day and age where debt is cheaper than it has ever been (and likely ever will be, expect interest rates to only go in one direction, up), people have been gorging on the stuff like a fat kid in a bakery.
Canadian household debt is now greater than the entire country’s GDP, and the US isn’t faring a great deal better at around 80% (though this is falling, whilst Canada’s is soaring). For this, we can largely thank the global financial crisis. From September 2007 to January 2009, the US Federal Fund Target rate dropped from 5.25% to 0.25%, and kept it there until December 2015.
Expectations going forward are for consistent interest rate rises from the US (already begun and expect another 2 rises in 2017) and you can expect the same in Canada eventually, where more than 90% of the time they follow whatever direction US rates go.
So with everybody seemingly swimming in debt, surely this is a recipe for disaster? Well, yes and no. It all really depends on the kind of debt you are holding. The vast majority of Canadian household debt is tied to mortgages, and whilst this much debt is still going to result in disaster (hello housing crash) it’s nowhere near as bad as consumer debt.
So let’s take a look at what good debt, bad debt and the mysterious world of borderline debt is.
“It takes money to make money” is a well known adage, and any debt that is taken on in order to increase your wealth can be classified as good debt. Some examples of this debt are:
- Student Loans – A valued education has a very positive correlation to better employment opportunities, all over the world. Well educated people are more likely to be employed in well paid careers and as such, taking on student debt in the short-term should pay off in the long-term. That is, of course, unless you studied something like Fine Arts or Philosophy, where you might as well come out and start looking for a new career path immediately.
- Real Estate – This is a pretty obvious one, and the one most people strive for in their life. Whether or not I agree with it (I don’t right now, in Canada at least), money can be made by buying a house with a mortgage, either living in it for many years before selling it, renting it out to create a passive income or simply flipping it (though the latter often won’t use leverage).
- Business Ownership – Borrowing money to start a business is also another form of good debt, assuming you have a good business idea. You might want to re-think taking out that $100,000 loan to fund your chocolate fire guard business though.
Whilst good debt might seem like a no brainer then, it doesn’t always go to plan. 8 out of 10 businesses fail in the first 18 months, real estate can crash (2008) and higher education is, well, rather pricey to say the least.
Whilst good debt can have upsides if used correctly, bad debt basically never has a good side. Bad debt is any debt taken on to purchase depreciating assets, or assets that do not go up in value. Examples of bad debt are:
- Cars – Cars are one of the worst investments a person can make, they lose value the moment you drive it out of the dealership. If you take out debt in order to finance this new car, it’s a double whammy of idiocy and likely the worst financial decision you will ever make. You will immediately be paying significantly more than the car is worth and potentially tying yourself to a lifetime of monthly repayments for something that is guaranteed to go down in value. In fact, if you have any hope of reaching financial freedom, the first thing you should do is stop buying new cars, and stop buying any cars using debt.
- Credit Cards – What you buy on a credit card isn’t necessarily the issue, it’s the credit card itself. If you do not pay off your credit card, or only pay off the minimum amount, you will be getting slammed with massive interest charges every month. Since most people use credit cards for day to day purchases it is unlikely that you will be buying anything that provides an income stream that could cancel out the massively detrimental interest.
- Consumables & Other Services – This is similar to credit card debt and could range from anything from clothes, vacations, technology, fast food and groceries. If it is paid for with debt, the interest you are paying on it is like flushing your hard earned cash down the crapper.
I just made this name up, but there are some types of debt that fall somewhere between bad and good debt, so borderline seemed a sufficient title if I may say so myself!
- Leveraging – This is a term used to describe debt taken on to purchase an asset that will increase in value at a faster rate than the interest rate on the debt (at least that’s the intention!). If you take out a $100,000 loan at 3% to invest in the stock market, and invest it expecting a return of 7% per year, then this is an effective use of leveraging (assuming after tax returns are still above 3%). This is obviously a risky form of debt, however, and if your gamble doesn’t pay off it’s compounded by the fact you are paying interest on top of the losses you have made on the investment. That being said, many people take advantage of leveraged investing, using other peoples money to make shrewd investments that pay off on a big scale. If you do get it right, the rewards for the gamble can be significant. The phrase “it takes money to make money” is certainly an accurate one when it comes to leveraging.
- Consolidation Loans – On the one hand consolidation loans are a great form of debt. If you have various types of debt dragging you down with high interest charges, leaving you unable to pay them all off, consolidating your debt into one manageable repayment can certainly improve your financial situation. On the other hand, however, skeptics say consolidating loans simply give people who are irresponsible with money more freedom to get into even more debt, thus worsening their already dreadful financial situation.
Overall I’m a very conservative person when it comes to debt and I’ll usually do my best to avoid it. I was 24 before I took out my first credit card due to the amount of horror stories I heard about them, and I see all too often how even good debts like mortgages and business loans can come back to bite a person in the ass.
Eventually I will probably dabble with other forms of debt but for the time being I’m quite content keeping my head above the water and chipping away at increasing my investments of my own free will.