Good debt or bad debt? How to tell the difference and use debt to your advantage.

#Managing your money

Not all debt is equal. Some types of debt are more harmful to your financial security than others.

Often, we associate debt with poor financial decisions that hurt your financial plan. But there’s such a thing as good debt and bad debt. Here’s how to tell the difference between the two and how to tackle them.

Good debt

Good debt sounds contradictory, but it’s not. Good debt can be a sound investment that results in long-term benefit for you or a product that increases in value. For example, taking out a loan to start a business, a mortgage or to pay tuition. In the latter example, your student loan financed your education – an investment in yourself which benefits you professionally and benefits your financial plan in the long term.

Good debt can also help you to build a positive credit rating. This can help you make big purchases like a house or car and can even help you get a loan. Good debt generally has lower interest rates and contributes to achieving a goal, whether that’s owning your home or earning your degree. 

Bad debt

Bad debt is what we normally think of when considering the term debt. This could mean borrowing money when you don’t have enough to purchase a product that won’t increase in value. Payday loans and credit cards are two examples of bad debt.

Bad debt typically has a negative effect on your credit rating (although a credit card can sometimes help you build your credit rating). Loans that are bad debt usually have high interest rates and tend to result from impulse purchases.

How is debt affecting your financial plan? Are you dealing with bad debt? Or are you building your credit rating for a big purchase? Let’s look at what you can do now to help improve your financial situation.

How to manage multiple bad debts

The best approach to manage debt is different for each person’s situation. Generally, you should try to pay off bad debt first, then focus on the good debt. If you have multiple bad debts, compare them to find the one with the highest interest rate. Continue making minimum monthly payments on all debt, but devote the most money to pay off the debt with the highest interest rate – fast. Eliminating the highest-interest debt first will save you from paying more interest over time.

Your financial security advisor may recommend you combine your debt – one monthly payment with a lower interest rate – depending on your personal situation. They can also help suggest debt solutions that will keep more money in your pocket. For example, if you have a line of credit for a home improvement, some financial institutions will convert this into part of your mortgage which could significantly reduce the interest you pay.

You could also make weekly or biweekly payments on your debts. If interest on a debt builds up daily, then the faster you can reduce the daily balance, the less interest you’ll be charged at the end of the month.

Once you’ve cleared your bad debt, consider how to pay down your good debt in the same way. Pay down the debt with the highest interest rate while making minimum payments on the rest.

Living with – or without – debt

When you take on debt, you’re essentially borrowing from your future paycheques. Once you’re debt-free, you can start investing the money that you would have used to pay off your debt. That means you’re essentially contributing to your future paycheques, which is a great financial position to be in.

Avoiding bad debt is the healthy approach to managing debt. That means living within your means. You might consider shredding credit cards, putting them in a jar of water in the freezer or stopping the impulsive use of payday loan services. Either way your future self will thank you.

If you’re unsure about how to approach your debt (good or bad) you don’t have to tackle it alone. A financial security advisor can work with you to create a strategy that may help benefit you in the long term and make sense of your financial picture.

Here’s how to differentiate between good debt and bad debt, as well as a suggested approach for paying off debt.
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This information is general in nature and is intended for informational purposes only.  For specific situations you should consult the appropriate legal, accounting or tax advisor.

The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature, and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.

 

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