Just yesterday, this very question was presented. What is classed as ‘Good Debt and Bad Debt’. Well, the most simple rule is if it increases your net worth or has future value, it’s good debt. If the debt doesn’t increase your wealth or you don’t have the cash to pay for it, it’s bad debt.
You know that old saying “it takes money to make money,” well good debt helps you generate income. Here are a few examples of when going into debt can increase your net worth:
- Education: increases your earning potential and great return on investment
- Real Estate: is just a great investment and you could also generate income through renting your property where the tenant can cover your mortgage payments. You have to live somewhere so you might as well gain value from your investment. On the down side, we have learned over the past few years that price appreciation is not guaranteed
- Investment: very important to look at your risk tolerance and whether you want short or long term investment. Where is your expertise? Personally, I like investment in mortgages, it is what I know best
- Business Ownership: you will be your own boss and you are not reliant on a third party to employ you but it’s not for everyone
Here are a few examples of Bad Debt:
- Credit Cards: with the interest rates of credit cards, this is a great example of bad debt. If you just pay the minimum balance each month with a credit card of 14%, it would take you approx. 22 years to pay the balance in full
- Pay Day Loans: I wish they would close these companies down. The idea is to just borrow until you get paid but if you don’t pay these loans, I have read that the annual rate charged is around 400%
- Vehicles: especially new cars which depreciate as soon as you drive it off the lot. Possibly a good used vehicle will accomplish your goals as opposed to paying interest for the next 5 years. Try to pay off the loan as quickly as possible
- Consumable Goods and Clothing: these purchases are for personal enjoyment, there is no future value in these items
You may wish to calculate your debt to income ratio. This is what the lending institutions use to determine whether they will or won’t lend you money! Get a total of all your monthly payments, mortgage, loan, car and credit card payments. Then divide this by your gross monthly income. Say your total payments equal $2,500 per month and your income is $5,000 per month, this means your debt to income ratio is 50%. In order to get a mortgage with a perfect credit rating, your debt servicing ratio is maximum 44% (including your property taxes + heat), therefore you would not qualify for financing.
Possibly a debt consolidation mortgage would be helpful. If you would like to explore some options to help you with your finances, I would be pleased to discuss this with you.
Colleen Saunders is a 20 year veteran in the mortgage industry, serving Oakville, Burlington, Mississauga and Toronto and offering all mortgage related services such as 1st & 2nd mortgages, private mortgages and more.
To contact Colleen, please fill out the form on www.mortgagesbycolleen.ca or call 416-459-2406