To my readers: I keep getting emails from Canadians asking me about debt – so today we’re going to look at the differences between “good” debt and “bad” debt. Then next week I want to show you how you can use debt to increase your wealth. So let’s get started.
It’s not hard to find a headline on social media to warn of high levels of household debt in Canada. This may be true, but to an extent. Interest rates have been kept low on purpose in an effort to support the economy through COVID and Canadians have taken advantage of this new financial environment. Most of us have embraced our credit and gone to great lengths to reduce our personal debt in an effort to strengthen our overall financial position. Today, Canadians owe about $ 1.63 for every after-tax dollar they spend. You may think that this is a large amount that demonstrates our propensity to obtain credit on a regular basis, but it is not. We have drastically reduced that number over the past 18 months, to $ 1.97 for every tax dollar earned in 2019.
There is a difference in the type of debt you hold, and while it would be great to be rich and debt free, you have to remember that debt is also a tool to make yourself rich. When I was an advisor to very wealthy clients who had literally millions to invest, they too had debt, but this was used to increase their wealth and not to spend on more depreciable assets like luxury cars, boats and cars. toys. Instead, they would use the debt to get and buy stocks or investment property; essentially, spending that debt on any appreciating asset that would give them a higher rate of return and, in most cases, a write-off of interest tax on borrowed funds.
Most Canadians think of debt as a “bad thing” and many feel quite nervous or insecure when considering taking on debt to make money. However, this is exactly what the vast majority do. We use debt for home and auto financing, home improvements, and education. Debt that improves a person’s ability to purchase assets such as homes, vehicles, or investments; or is used to increase their income through business or education are all good debt. Many advisers would agree that these expenses are inherently appropriate today, and it is important for us to focus on what these borrowed funds will allow the household to accomplish and whether they will improve wealth in the long run.
Bad debts are loans that do not promote wealth or income prospects, but instead provide enjoyment and an increased standard of living that cannot be supported by income alone. This would include items like balances on unsecured lines of credit, credit cards or personal and consolidation loans. Some borrowers make a habit of using credit to fill their income gaps, believing that they cannot survive on their own income and need the credit to increase their standard of living. This type of borrower, whether old or young, presents the most risk today, even in a low interest rate environment. They sometimes feel like they just can’t earn enough for their lifestyle, but in reality they are living just beyond their means, don’t want to sacrifice more and step out of their comfort zone to bring changes to improve their situation. These borrowers would indeed be in a vulnerable position in the event of disruption in their income or if interest rates start to rise, (which they will). This habit must be broken to avoid becoming a chronic borrower in debt for life. If it’s you or someone you know, try making a new financial plan to make the necessary changes you know you need to make to live on a budget. Devise a strategy to put down your debts in order to create a stable financial future.
We must remember that the low interest rate environment will not last forever and that we must never settle for our debt – good or bad. You should always have a strategy to pay off every debt in full during the life of the asset or at least in retirement. Always be planning. You can’t expect to have a future if you don’t plan to have one.
Ask the Money Lady is written by Christine Ibbotson, author of four books on finance, including the Canadian bestseller “How to Retire Debt Free and Rich”. If you have a money question, go to www.askthemoneylady.ca or send a question to [email protected]