Understanding debt: The good, the bad and the ugly
Not all debt is bad. Knowing the difference between bad and good debt will help you make better financial decisions.
Now sitting at 163 per cent of disposable income, the debt load of Canadians has become alarmingly high — just about the same level that existed in Britain and the U.S. before their housing bubbles burst.
But not all debt is the same. There’s the good, the bad and the downright ugly.
To me, good debt is taken on for a significant and long lasting benefit. The classic example is a mortgage to buy a house or condo. But even here there are caveats. If the debt is too large for your income, it increases stress and exposes family members to undue risk.
There’s also the issue of opportunity cost. When mortgage debt turns you house poor, there’s no money available for some of life’s important pleasures such as sports for the kids or hobbies for parents. And saving for retirement, education or emergencies often goes out the window.
Education is also typically cited as a good debt, but here too there are caveats. Though I believe in education for its own sake, gone are the days when you could inexpensively sample university life.
One way for a student to help ensure that their education debt falls into the good category is for them to take a gap year or two in order to save and to explore their employment goals. Another option is an unpaid internship. It won’t fatten their bank account but it’s a great way to test the waters of what they want to do.
I’ll give you an example of a good debt from my own life. Fifteen years ago my family bought a small farm, which was in terrible condition. It quickly became apparent to us rural newbies that we couldn’t manage without equipment — an aging Toyota station wagon didn’t do so well on fencing duty in a muddy field.
We bought a tractor for $3,300 cash — a beautiful 1952 Ford 8N Diamond Jubilee model but it broke down constantly. So, we turned a bad choice into good debt by using it as a down payment on a brand new John Deere with a front-end loader and a blade for clearing the snow off a long driveway.
To me this was good debt because we could afford the payments and without the tractor we couldn’t operate our farm.
Bad debt is usually the result of discretionary consumption — clothes, electronics or a bigger, better, more up-to-date whatever. Often these purchases sit on credit cards and credit lines. The majority of household non-mortgage debt falls into this area.
Bad debt is disheartening and few can actually name all the items purchased as it grows. Even worse is buy-now-pay-later debt for things like appliances, hot tubs or furniture. When the sum isn’t paid off by the deadline, it becomes a high-interest debt and sometimes the accumulated interest is added to the principle.
Far too many people borrow 100 per cent in order to purchase a car but at least it becomes an asset once the big depreciation of the first couple of years have passed.
I recall one family featured on my television show, “Maxed Out.” They had two very good incomes but, to their dismay, $90,000 in line-of-credit debt and they couldn’t figure out where the money had gone.
When I met the couple and their three children I immediately had my suspicions. There were all rather plump. After a little snooping through their cupboards and garbage — oh, the glamour of being a TV host — my suspicions were confirmed.
This family hadn’t cooked for years. They bought prepackaged meals, takeout or restaurant fare for breakfast, lunch and the majority of dinners. I estimated that that they were spending around $800 a month extra on this unhealthy diet. This habit, plus interest, was the primary source of their $90,000 in bad debt.
Ugly debt is money owed to family or friends. Though I’ve known a few instances where it works well, this type of borrowing often breeds acrimony and resentment.
A major part of the problem is the lack of distance between the parties. It’s quite difficult to be firm with friends or family when it comes to missed payments or no payments at all.
Another issue is lack of documentation laying out the debt, interest and payment schedule. After a few years, memories tend to fail when it comes to financial specifics. If you must borrow from friends or family, get it in writing just as if the lender were a bank.
What kind of debt do you have — good, bad or ugly?
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