Til Debt Do Us Part – Part 1
Good Debt vs. Bad Debt
by Arnold Machel, CFP®
“The wicked borrow and do not repay...” Psalm 37:21
It’s been my experience that one of the biggest points of contention between spouses is debt management. Trying to navigate debt for oneself is hard enough. Factor in competing ideologies and feelings about debt and you have the perfect storm for marriage partners. Good pre-marital counselling will touch on this emotionally charged money topic, but until you are actually in the situation, it’s hard to know how you and your spouse will react.
There are a handful of questions that often come up about debt. Under what circumstances should one take on debt? What’s a reasonable amount to be in debt? And then how much should one dedicate to that debt repayment?
Let’s start with that first one: When is it OK to borrow money?
I classify debt into two very simple categories: good debt and bad debt. In very broad terms, good debt is money borrowed for the purpose of investing in something that will either accrete in value or generate an income at a rate greater than the cost of borrowing. Bad debt is all the other debt.
Usually it’s pretty clear when debt is good. When you are borrowing to buy something that will likely appreciate in value or will generate significant income or both, it is usually good debt. Usually buying a home is a good deal and would fit in the good debt category. Solid investments can fit into the good debt category. They may also have the added advantage of providing a tax deduction for the amount of interest paid, effectively reducing the cost of borrowing.
But there are some grey areas. By and large, when purchasing a home, there are two components to the home: land (which goes up in value over time) and building (which usually goes down in value over time). If you buy an exceptionally nice condo in which the vast majority of the value is the building and not the land, then you may be sliding into bad debt territory. At the very least consider having a much bigger down payment if you are buying a place with little land value relative to building value.
Generally, most consumer debt is bad debt. Some examples of bad debt are money borrowed to…
* Go on a vacation
* Buy an entertainment system
* Make ends meet because you are living beyond your means
It’s easy to under-estimate the cost of bad debt. After all, the monthly payments don’t seem so big. Let’s look at a typical credit card bill. Fred bought Christmas gifts for his wife Wilma and their daughter, and ended up putting $5,000 on his credit card. The rate is 15 per cent, but the payment is only the greater of $30 or 3 per cent of the balance, so it starts off with the minimum payment of $150 per month.
If Fred only pays the minimum required each month, it will take him over 11 years to finish paying and he will have paid $3,158.82 in interest. And that’s just for the one Christmas of splurging.
I call this debt bad, not because of the cost, but rather because it is indicative of a lack of ability to control one’s spending. These are all items that one should save up for and then buy.
What about a car? This may come as a surprise, but typically that’s bad debt. Buy a beater or take transit and save up until you can actually afford the car. You’ll be much better off in the long run. But there can be exceptions. If you are in a situation where a nicer or more reliable car is necessary for your work, then borrowing might tilt into the good debt range. The problem here is that it’s just a little too easy to talk oneself into “needing” a nicer car, so be very careful with that justification. Usually a “nicer” car isn’t a need; it’s just a want.
How much should one borrow?
Whether good or bad, it’s also key to ensure that the ability to pay the debt is never compromised. When borrowing from the bank to buy a house they have great rules of thumb to ensure that there is sufficient coverage, but if you are borrowing from a third party, it’s critical to do the math (or get an accountant to help you) to ensure that you are able to maintain payments for the period of the loan. Give due consideration to negative eventualities and make certain that both you and your spouse are comfortable with the risk you are taking.
The banks won’t let you spend more than 40 per cent of your income on debt payments. When you hear them refer to your TDSR, that’s what they are talking about: your Total Debt Service Ratio. It’s how much you are making in debt payments compared to your income. That doesn’t mean you can’t spend more than that – just that you can’t put yourself into a position where your minimum payments exceed that.
And generally, that’s a good rule of thumb, but if you have a very high income and an unusually high savings rate, then, maybe, you might be able to afford a higher amount.
Over the years I’ve come to believe that Canadians generally do a poor job of differentiating between the two types of debt. We tend to lump all debt into the “bad” classification and often are so focused on paying down and/or not incurring good debt that we nearly kill ourselves to burn the mortgage papers. This is somewhat surprising in that most Canadians would agree that borrowing to buy their home was one of the best things they’ve done financially. If it was so good, then why are we so anxious about it and so opposed to repeating it?
Yes, paying off bad debt is critical. In fact, it should never be incurred in the first place. But don’t be so afraid of going into good debt.
We should be less concerned with avoiding and getting out of debt generally, and more concerned with ensuring that when we do go into debt it is only good debt and then managing it appropriately, so that it’s not putting an undue stress on our lives in the short run and it’s providing a financial gain in the long run.
Next month we’ll drill down on what to do if you’ve let your debt get out of hand.
Arnold Machel, CFP(r) lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at firstname.lastname@example.org<mailto:email@example.com> or through his website at www.visionvest.ca<http://www.visionvest.ca/>. Please note that all comments are of a general nature and should not be relied upon as individual advice. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.