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The difference between good debt and bad debt

The amount of personal debt in Canada has been increasing over time. This article featured on the CBC makes a good point about how we are comfortable carrying debt. According to Statistics Canada, our total national debt load, including mortgages, sits at slightly more thatn $1.8 trillion. WOW. Plus, the average household debt increased from an average of $46,000 to $110,000 between 1984 and 2009, according to Canadian Living.

It’s not that we are taking up more debt because we want to. It’s more because we need it. The ability to borrow money has never been easier and the low interest rates to buy homes make us comfortable carrying debt.

We need to understand not all debt is bad. Let’s take a look at the differences between good debt and bad debt.

What is good debt?

Simply put, good debt consists of sensible investment in your financial future. It mostly leaves you better off in the long-term and doesn’t have any negative impact on your overall finances. Good debt means you are taking it out for a clear and specific reason. You also have a realistic plan for repaying it so you can clear the debt as fast as possible. If you can make regular and affordable payments, then you definitely can borrow some good debt.

If you have identified the cheapest possible way to borrow money, that smells like good debt. A little homework and comparison shopping should reveal the borrowing method, the interest rate, loan amount and term, and the most appropriate charges. In most cases, good debt is available at low-interest rates.

Examples of good debt include:

Student loan: Taking a student loan to pay for college and university education is good debt. In fact, the majority of the Canadians take student loans. Student loans are more flexible, have a low-interest rate and increase your chance of finding you a job in the future. Take advantage of it.

Mortgage: You get to pay a mortgage against your own home instead of paying rent. This makes it good debt. It is akin to forced savings instead of building wealth for someone else.

Investing in your own business: This is a tricky one, but if you can make it work, it pays a lot of dividends. When you get a loan to start a new business or invest in an existing one, some view it as good debt. It just depends on how you use the loan.

What is bad debt?

This is easy. Bad debt drains your wealth, is not affordable, and offers no real prospects of dividends in future. Borrowing money to pay for things now, rather than saving a few months for them leads to bad debt. For instance, you take a loan to buy a huge screen TV and pay in monthly instalments instead of waiting until you have saved enough to pay it in full amount. Bad debt is when you are living beyond your means or trying to “Keep up with the Joneses.”

Examples of bad debt include:

Getting any loan you can’t afford to pay off: If you don’t need that tv, don’t buy it. Or at least save up and buy it rather than taking out a loan for it.

Predatory loans: They’re the worst. Read up about preadotry loans here.

Credit Card debt: Also one of the worst debt to have because they carry high interest and tend to be self-perpetuating. It’s one thing to bite the bullet one month, but carrying a high balance for a long time makes it extremely difficult to ever get out from underneath the burden.

Always say no to 29.99% interest that many cards are charging you. Often, you’d be better to get a personal loan, but the best option is of course, saving up for whatever you want to buy.

It is important to understand good and bad debt may overalp at times. A mortgage could end up being a bad debt if you bought an oversized house, trying to keep up wth the Joneses. The answers for good and bad debt aren’t always vivid. That’s why it’s always important to determine why you need to take on debt, and what the long-term consequence will be.