When good debt goes bad

Amid rising economic uncertainty the notion of good debt could backfire.

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The concept of good and bad debt is fairly straightforward: bad debt loses value, while good debt gains in value.

A large credit card balance, for example, is a bad form of debt because all those gadgets and groceries you paid for lose value the instant you leave the store. A mortgage, though, is good debt because you’re buying something that you expect will increase in value over time.

When the economy was booming, it was clear which debts were good and which ones weren’t. Student loans allow you to continue your studies, which, in turn, can help you get a better paying job; an investment loan can help you make more money when markets rise. But the distinction between good and bad debt may be blurring.

“The premise of good and bad debt is still the same,” says Laurie Campbell, CEO Credit Canada Debt Solutions in Toronto. “But in today’s economic uncertainty, all (good debt) could backfire.”

If things do backfire, the first casualties could come from the housing market. When interest rates rise many experts believe the housing market will fall—perhaps significantly. While it’s too early to tell what will happen and if it will affect every city the same way, the fact remains that sudden house price drops mean good debt could quickly turn bad.

Let’s say you have a $650,000 mortgage on a $750,000 house. If the value of that house fell by 20% it would be worth $600,000, or $50,000 less than what you originally borrowed to buy the home. Over the long-term, housing prices could rise again, but if they don’t then you could be stuck with an asset that hasn’t changed in value or depreciated over time.

Garrett Sutton, a Reno, Nev.-based lawyer and author of The ABCs of Getting Out of Debt, says good debt is something that allows you to advance your financial goals. He’s seen first hand how good debt can turn into bad debt. Nevada has one of the highest foreclosure rates in the country. People there thought they were buying places that would make them money one day, but then the market crashed and their homes lost a lot of value.

These days there are “limited situations where you can have good debt,” says Sutton. Unfortunately, situations he identifies also involve risk. Buying a investment property, where there’s an expectation of regular monthly income, can be considered good debt. The same goes for owning a business that offers a stable income stream. Of course, businesses fail and rental properties need tenants, so there’s no guarantee that these things will be a good use of credit.

If you are looking for an example of a way to borrow that involves less risk then consider taking out a loan to invest in an RRSP. Campbell thinks this is a good use of debt, but only if the money is used wisely. Put the cash in a GIC, to keep it safe, she says. While a GIC will only give you a small return, you’ll get a higher tax refund. If you invest that refund back into your RRSP it will help boost portfolio returns over time.

However, it’s important to pay back the loan as soon as possible, ideally within 12 months. “If you have to pay back a $10,000 RRSP loan over three years are you really ahead?” she asks. “It’s hard to say.”

Even if the line between good debt and bad debt is narrowing, there are other reasons to buy a house or go to school than financial gain. Likewise, taking on bad debt can sometimes help you in other ways—most people need cars to get around.

Ultimately, in today’s economy, and with Canadians so heavily indebted, people need to be more aware of how their debt is working for or against them. “Debt is not a bad word,” says Sutton. “It’s allowed people to achieve their financial goals. But you have to be very cautious about distinguishing between good and bad.”

3 comments on “When good debt goes bad

  1. I've always been taught that all debt is bad–and was blessed to be able to go to college by taking on absolutely no debt.
    It's been really hard for me to see so many peers that have been told that college debt is normal and an investment in their future have a huge burden places on them that really makes you wonder how "good" of an investment it is.
    Great article.

    Reply

  2. I love the line "..good debt is something that allows you to advance your financial goals..". I don't know about you, but going backwards to try and end up forwards very seldom makes sense. The only exception in my opinion is when you are going in the wrong direction in the first place. Debt is not a necessity. It is a convenience that allows us to have what we feel we need right now. Then it becomes a question of how much are we willing to pay for it. I have never fully understood how and why people go in debt so quickly. Parents often know they want their children to attend college or university so why not plan for it. You likely will want to purchase a house one day so why not plan to purchase the smallest house that fits your needs with the least amount of debt as possible. Save for your down payment and plan. It is not like we purchase these things on whim and hope it works out. Or maybe we do, hence consumer debt. Debt is not good. It means you owe someone else plus a fee for them helping you get what you want when you want it. We teach patience is a virtue but can't seem to be patient when it comes to financial gain.

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  3. I took out a substantial investment loan at the beginning of 2009 and it paid off nicely. I maxed out my RRSP and started paying down heavily my personal (bad) debt with some of the money I made. This month I am going to be (bad) debt free but I still have the original investment (good) debt left. The investments and the loan are basically at the same value now (b/c I pulled money out to pay off stuff) and I was considering cashing it out all together and being completely debt free. Not sure if that is a good idea. Any ones's thoughts?

    Reply

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