You probably know there are different types of debt, but do you know what the difference is between good debt vs. bad debt? While it might seem odd that any debt at all can ever be considered a "good" thing, there are some types of debt that can give your overall financial profile a boost, as long as you can responsibly pay it back. Find out what types of debt can be considered "good" and "bad" and their potential impact on your financial outlook.
Good Debt vs. Bad Debt: What’s the Difference?
At Credit Canada, our certified Credit Counsellors are experts when it comes to debt—they know the good, the bad and the ugly and they've seen and heard it all. What typically separates good debt from bad debt is that good debt usually refers to debt you've taken on that will ultimately increase the value of an asset — like taking out a mortgage to purchase a home — while bad debt is debt you've incurred to purchase items that don't generally increase in value over time; in fact, they often depreciate in value! Bad debt includes credit card debt and auto loans, while payday loans are considered, within most financial circles, as "ugly" debt. Here’s a closer look at good debt vs. bad debt and why they're viewed this way in the eyes of most credit bureaus, lenders, and financial experts.
Good Debt: Mortgages
Although mortgage debt among Canadians has reached close to $1.44 trillion, this isn’t necessarily terrible news, because mortgage debt can at least be considered "good" debt, as long as you can keep up with your mortgage payments as agreed. Why is mortgage debt generally considered good? Because owning a home builds equity you can use in the future, rather than just giving your rent money away every single month, never to see it again. Plus, real estate and property values tend to appreciate in value over time, and mortgage loans generally have very low interest rates. And while mortgages are usually long-term loans that can last up to 30 years, this allows payments to be kept relatively low, freeing up your money to make money-making investments or pay down bad debt.
Good Debt: Home Equity Loans
More than 3 million Canadians have a home equity line of credit, or HELOC, borrowing money against their home to pay off non-mortgage debt. This is considered good debt—or at least “better” debt—because HELOC’s typically have much lower interest rates than bad debt, like credit cards or payday loans. But it’s important that borrowers understand that banks can raise the interest rate of a HELOC or demand payment at any time. As one expert from the Financial Consumer Agency of Canada (FCAC) put it: "You can't deny the fact that for the consumer it is a cheap source of credit. However, you have to use it well.” Also, you don't want to start treating your home like an ATM, because eventually you'll have to pay it all back, with interest of course.
Good Debt: Student Loans
Student loan debt in Canada has reached an estimated $22 billion, and while paying it off can be daunting for new graduates, at least they can console themselves with the fact that it’s considered good debt. That’s because receiving a post-secondary education is expected to earn you a higher salary over time. In addition, like a mortgage, student loans typically have much lower interest rates than bad debts (plus, the federal government has lowered the interest rate further in 2019).
Bad Debt: Credit Cards
Credit card debt is considered bad debt because most items you purchase with credit cards usually depreciate in value over time. Plus, the interest rate on most credit cards doesn't make it financially smart to carry credit card debt. That's why it's always best to pay off your credit card balance in full every single month. Otherwise, the only thing that's increasing in value over time is your debt, not your assets.
Let's say you purchase a new smartphone for $700, and you put it on your credit card which has a 19% interest rate. If you only make the minimum monthly payment (which we'll say is 2.5% of the balance, but every creditor is different) of $17.50, it will take you over ten years to pay it off, and you’ll have spent more than $750 in interest charges! By the end of those ten years, that phone will be worth next to nothing and you’ll have spent more in interest charges than what the phone actually cost you. Our advice? Just say 'no' to credit card debt.
Our free Debt Calculator can help you figure out how much your debt is actually costing you, as well as other debt repayment options that can save you money and time.
Bad Debt: Auto Loans
Although it’s possible to get around without a car and save a lot of money, most people consider it a necessity. However, as soon as you drive a car off the lot, it starts to lose value—and continues to lose value very quickly. In addition, they often have high interest rates, which further contribute to their status as bad debt. If you’re in the market for a new vehicle, buying a used car over new is best. But if your heart is set on buying a brand new, never-been-used-before car, it's usually better to consider leasing since it’s a depreciating asset. For more on the debate between leasing or purchasing a new car, click here.
Ugly Debt: Payday Loans
Many Canadians have found themselves in a never-ending payday loan cycle. Nearly 2 million Canadians use these types of "bad" loans each year, while 50% have taken out more than one payday loan in the last three years. Payday loans are what we consider the ugliest of debt, far worse than even credit card debt, because their interest rates are astronomical. They can reach as high as 650% depending on the province you live in. (Looking at the annual interest rate or APR on payday loans versus the bi-weekly interest rate, which is what the consumer sees.)
For example, in Alberta, British Columbia, New Brunswick and Ontario, you pay a maximum of $15 for every $100 borrowed on a payday loan, which works out to an APR of 390% while in PEI you can be charged up to $25 for every $100 borrowed, which works out to an APR of 650%! And if you can’t make your payment, penalties are also imposed while your debt continues to accumulate interest. The payday lender may also sell your loan to a collection agency, further lowering your credit score. If you’re stuck on the “payday loan treadmill,” check out our story How to Pay Off Your Payday Loan.
Bad Debt Help Is Available!
Now that you know the difference between good and bad debt, you might be wondering about your options when it comes to getting debt help. If you’re drowning in debt, and not the good kind, there might be a number of different debt repayment options available to you. For example, one way to pay off your bad debt is with a Debt Consolidation Program or DCP through a non-profit credit counselling agency, like Credit Canada.
A Debt Consolidation Program (DCP) is an arrangement where a certified Credit Counsellor negotiates with your creditors on your behalf to reduce or eliminate the interest on your debt. They will also roll all of your unsecured debt payments into one, lower monthly payment that is easier to manage, while taking into consideration all of your other monthly expenses. Although only unsecured debt can be consolidated through a DCP, by lowering these monthly debt payments you’ll have more money left over to put towards paying off your good debts. Interested in learning more about a Debt Consolidation Program, or have more questions about good debt vs. bad debt? Contact us at 1.800.267.2272. We can talk to you about how to be debt free, and all of our counselling is free and confidential.