Money & Career

Good debt or bad debt: Do you know the difference?

Good debt or bad debt: Do you know the difference?

Author: Canadian Living

Money & Career

Good debt or bad debt: Do you know the difference?

Canadians are more in debt than ever before. According to Statistics Canada, between 1984 and 2009, household debt in Canada more than doubled, from $46,000 (in 2009 dollars) to $110,000. And in February 2011, the Vanier Institute of the Family reported that the average Canadian family debt had hit $100,000.

While no one wants to be in debt, sometimes it is justified for future gains: what experts call "good" debt.

What are good and bad debt?
Good debt is defined as anything that builds your assets or increases the potential for you to earn more money. This includes categories such as:
  • Mortgages
  • Student loans
  • Investment loans
  • Rental properties

Bad debt is generally everything else, including:
  • Credit card balances
  • Lines of credit
  • Bank, car and other loans

How much good debt is it OK to have?
We'll focus on home and RRSP loans as they're the most common forms of good debt. It's important not to assume that because any money you owe is tied to home ownership or RRSP contributions, you're fine and operating in the good debt zone. Your choices can put you further into bad debt if you're not careful.

Should you take out an RRSP loan?
Every year, banks tell us to borrow money to top up our RRSP contributions -- after all, we can pay it back later, at a relatively low interest rate and on a schedule.

However, if you can't pay the loan off in less than a year, you've just gained bad debt. When the next contribution period comes around, you might borrow again but you're still paying off the first loan -- at which point good debt becomes bad and the value of the investment is likely being negated by the long-term loan payments.

The lesson? Only take out an RRSP loan if you can pay it off quickly and with minimal interest. Even better: start or increase your monthly RRSP contributions and have your employer reduce the amount of tax withdrawn from your paycheque.

Mortgages and housing: The good and the bad
"Home equity is a really good way to invest in your future," says Farhaneh Haque, director of mortgage advice at TD Canada Trust. "Borrowing money to invest in something like a home which will likely increase in value is good debt."

However, Haque warns that your monthly housing costs should be no more than 32 per cent of your gross monthly income, and your total monthly debt load no more than 40 per cent.

So if you and your spouse earn a total monthly gross income of $6,000, you shouldn't be spending more than $1,920 per month on your mortgage payment, property taxes and heating costs combined -- and any additional debt payments shouldn't bring you over $2,400 in total. If your estimated monthly housing costs are higher than 32 per cent, a reality check might be needed before you buy.

If you already own your home, doing things like expensive renovations, especially if you're over-improving your house or don't intend to sell, can put you deeper into debt, especially if you start using a line of credit.

The key?
Talk to professionals before embarking on a renovation. Find out if it will improve the value of your home and before you smash that first wall, make sure you've saved for it. Avoid anything with the whiff of credit.

Remember, don't use your good debt as an excuse to get into bad debt. Always talk to a professional and always look at the numbers before you take out any kind of loan.

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Money & Career

Good debt or bad debt: Do you know the difference?