What is good debt?
Given the growing concerns around Canada’s consumer debt crisis, it’s only natural to paint it in broad strokes as universally bad. However, that’s not always the case.
Debt is certainly problematic when it costs the borrower money and interferes with their financial goals. Yet, there are also situations when debt can help you build wealth or increase income over time. This is what many financial commentators call — for lack of a better term — good debt. Common examples include mortgages, student loans or lines of credit, business loans, and investment loans.
Let’s look at these in further detail.
Mortgages
As real estate prices have tended to increase over time, owning a home can often help you build equity over and above the purchase price and cost of your mortgage loan.
There are two ways to realize on this potential wealth:
- Sell the house and downsize to a less expensive residence
- Borrow against the equity via a home equity line of credit or reverse mortgage
The first option is by far the most preferable, as it provides cash to fund your retirement or support other financial goals. The downside, of course, is it usually requires holding onto the property for many years (often decades) to generate sufficient wealth.
The second option is by far the most common, as banks are typically happy to lend to homeowners with good credit and can use the house as security. However, a word of caution: While lending rates for mortgage loans are generally lower than comparable unsecured loans and lines of credit, this debt will still accumulate interest and must eventually be repaid. If you don’t plan to use the money to build wealth or equity (e.g. home improvements, investment, etc.) the better option would be leave the equity in the home.
Education
Growing your knowledge and gaining certifications in relevant fields can help you move forward in your career and significantly increase your earning potential. For that reason, taking on a manageable amount of student debt is often a worthwhile long-term investment.
As a rule, most financial advisors recommend you limit your borrowing to the expected annual salary for your area of study. For example, if research reveals your field of study will pay an average of $55,000 per year, try to keep your student loans at or below that amount. If you can set aside 10 percent of your monthly income for repayment, this strategy would help you pay off the debt within around 10 years.
Business loans
Owning your own business in an area where you are knowledgeable can help you become both financially and individually independent. As your own boss, you have the potential to set your own income and create intergenerational wealth for your family — and business loans can help get your vision off the ground.
With that said, it’s also important to remember that starting a business is a risky endeavour. The potential payoff is usually more than worthwhile for anyone with an entrepreneurial mindset, but it’s important to acknowledge you could be responsible for making the payments whether the business succeeds, or not.
Be prepared to work long hours, wear many hats (e.g. strategist, supervisor, financial controller, customer service, etc.), and withstand immense stress as you build your empire. You can also improve your odds of success by aligning yourself with a supportive financial institution, accountant, lawyer, and advisor.
Investment loans
A sound investment strategy is undoubtedly the most effective way to generate wealth and set yourself up for the future. Depending on your financial situation, a lender may be willing to offer a low interest rate loan to contribute toward this objective — which may be productive, provided the anticipated return is higher than the cost of the loan.
However, there are several considerations to keep in mind before taking on an investment loan:
- What is your risk tolerance? Investments are not foolproof; a recession or stock market crash can strike at any time. It’s possible you might end up owing on a debt that is no longer earning you money. How will this impact your financial wellbeing?
- What debts do you currently have outstanding? The most realistic long-term return on the stock market is approximately 10 percent per year. If your current debts are costing you more than that, it will benefit you more to pay those down than to take more debt for investment purposes.
- How is your credit? For an investment loan to make sense, your interest rate should be significantly lower than your expected rate of return. Is your credit and wealth such that you borrowing would be worth the time and expected risk?
A qualified and competent financial advisor can help you answer these questions and make a decision that fits your long-term goals and current financial capabilities.
Debt is debt
At the end of the day, all debt is a risk. As we’ve seen, good debt can position you to capitalize on opportunities — but nothing is certain. Any time you borrow money, you need to have a plan to pay it off and to avoid those payments from getting in the way of your other financial and personal goals.
If debt is causing a problem in your life — be it bad or so-called good debt — help is available to get the financial fresh start you need and deserve. Contact MNP for a Free Confidential Consultation today to review your financial situation, discuss your options, and start defeating your debt today.
