Uncommon Cents: Good and bad debt

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The 18th-century thinker, inventor and politician Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.”

He missed one: debt.

For every dollar we earn at present, Canadians owe another 51–61 cents. Our debt is, in other words, quite high. While some commentators are wondering if such debt levels are sustainable, there is another, more interesting question: what is good debt, and what is bad?

If students start thinking about this question now, they will find themselves years hence in a much better place financially than most of their adult mentors and parents currently do.

In addition to our debt, 67–80 per cent of Canadians do not have a plan in place for retirement. Tying these three financial pieces together emphasizes the importance of asking early on what constitutes good versus bad debt.

Bad debt results in superficial acquisitions that decline in value over time, while good debt results in substantial assets that increase in value over time. Bad debt costs you money, while good debt earns it.
Let us take a fictional couple, Angelina and Brad, as an example.

Brad loves cars and happily goes into debt to indulge in their purchase, maintenance and use. The trouble is that all cars and vehicles, no matter their original price tag, immediately lose value when they roll out of the showroom and onto the street. Over time they lose even more value and rarely, if ever, return the original cost of purchasing or borrowing to afford their acquisition. This is bad debt.

Angelina is of a more forward-looking nature and has more understanding of what is good debt, and so she and Brad buy a nice home on Hollywood Boulevard. They buy it for $450 000 in 2005, raise their children in it for 20 years, and live in it for another 20 before they sell it and retire to a small country villa on the beach. During these 40 years, the house’s value has doubled. It is now worth almost $700 000. This is good debt because Angelina and Brad took care of the property, paid down its debt fairly quickly and watched the value of their home, unlike that of Brad’s cars, increase over time. They have more value and equity in their financial portfolio than when they bought the house. “Equity” is the value of something beyond what is owed on it — if Brad an Angelina originally put a down payment of $150 000 on their home, they had equity of $150 000. As they paid off the house, their equity grew.

But their story does not end there. About 10 years into their ownership of the Hollywood Boulevard house, they realized that they had, between them, seven credit cards, and almost all of them were maxed out. Somehow they had never realized that credit cards charge the highest interest rates of any debt-causing instruments; one of them was a whopping 29 per cent. This too was bad debt because most of what they bought with those credit cards (shoes, clothes, socks — the usual stuff) did not build up equity or increase their financial assets. They decided to get a consolidation loan, pay this debt off and pay off their credit cards every month so that they would not end up in a similar hole in the future.

So, death, taxes and debt are all inevitable. The question is: how do we deal with them?

If you have an affinity for pricey, shiny things like Brad, it all comes down to your conscious efforts to understand what bad debt is, and to make informed decisions that will smartly plan your future.

Three sources of bad debt

1. Credit and department store cards (if not paid off monthly).

2. Vehicles (their value rarely, if ever, exceeds potential equity).

3. Many of the ‘toys’ we love (including many new technological items).

You don’t need to swear off these items; you just need to balance material wants with financial needs.

Three sources of good debt

1. Loans for education.

2. Mortgages.

3. Regular savings (Registered Retirement Savings Plans, Tax Free Savings Accounts etc.).

Your lifetime equity will be based upon these forms of good debt.

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