With the Holiday Season starting, we should be taking a careful look at our budget so that we can plan our shopping for gifts and other expenses responsibly. We’ve all heard so much about debt that it can almost be considered another four-letter word, but are there circumstances when it can make sense to carry some debt? It is possible to have “good debt” as well as bad.
If debt is used responsibly to help you save money on taxes and build your wealth, it can be a good thing. However, if you have a problem keeping your spending under control or you are not living within your means, then debt can be a bad thing – especially if you are being charged high rates of interest on what you owe.
Difference between Good Debt and Bad Debt
The way you can tell whether debt is “good” or “bad” is easy: If the debt grows your net worth, then it’s good debt. Bad debt does nothing to help improve your bottom line.
“Good” Ways to Use Debt
There are instances where borrowing may actually help put you in a better overall financial position, helping to generate income and to increase your net-worth. As they say, “It takes money to make money”.1. Real Estate
1. Buy a Home
Most of us do not have enough cash to buy a home and so borrowing helps us to purchase this asset. Your home should increase in value over time, while your mortgage should be decreasing.
If you are interested in investing in rental property, it often makes more sense to borrow than to use your own capital, since you can write off the lending costs. If the amount collected in rent covers most of the mortgage payments, then borrowing is probably the best way to go. Your own money is then available for you to invest.
2. Investing
If you borrow for the specific purpose of investing to create income you can write off your loan interest costs.
If you don’t have the cash on hand to invest in your RRSP, borrowing is another great option. It helps to reduce your tax burden and create a possible income tax refund, which you can then use to pay down your loan or other high-interest-rate debts. It will also keep you on track to build your retirement nest egg.
3. General Investing
Borrowing at a low interest rate and investing for a potential higher rate of return is another way to build wealth. However, this strategy comes with many risks and is not recommended for the inexperienced investor.
4. Education
Borrowing for your own education or to enhance your professional skills is considered good debt, as it often comes with career advancement and higher pay.
Borrowing for your kids or grandkids’ education may also be the wiser choice if it is a choice between carrying debt or touching your retirement savings. Your financial advisor or accountant should be able to help you decide which is the better financial option.
5. Small Business
It may make sense to borrow (as opposed to using your own capital) to buy a business. Borrowing frees up your own personal cash flow to use for other needs and for personal investments (RRSP).
Recommended Debt Ratios
It is important not to take on too much debt (even if it is good debt), as good debt can still put a strain on your cash flow and hurt your overall financial health. To find out whether the amount of debt you are carrying is manageable, calculate your debt to income ratio. (Debt payments/income x 100 = debit-to-income ratio.) For example, if you have $1,500 a month in debt payments and your income is $4,500 then your debt to income ratio would be 1500/4500 x 100 = 33%.
Calculate this number twice. Do the first calculation including only bad debt payments. The second time, include all debt payments. The bad debt ratio should not be higher than 10 or 15 percent, and your overall debt ratio should be well under 40 percent.
Credit Counselling Canada says your spending should be around the following percentages of your income:
35% – House expenses (rent or mortgage)
15% – Unsecured lending
15% – Utilities
10% – Savings
25% – Day-to-day living expenses
Warning Signs Your Debt is Getting Out of Control
It’s almost impossible to live debt-free but possible to keep bad debt to a minimum. It takes sacrifices and smart money choices.