The Difference Between Good Debt and Bad Debt
It’s a big part of our adult lives, most of us carry it and it has two identities. One side is the good which works for us to make us wealthier and the other is the bad which can financially ruin us. What is it? You guessed it … Debt!
To me, the definition of good debt is any debt that is used to grow assets and is tax deductible. If accelerated wealth building is your goal, it’s ok to keep a balance on good debt as the low interest after the tax deduction is a way to grow your wealth via other peoples money.
- An Investment Loan - For example, with the Smith Manoeuvre, the HELOC interest on a readvanceable mortgage is 100% tax deductible providing that the HELOC is invested in income producing assets.
- Rental Mortgage – The interest on mortgages obtained for rental properties are tax deductible. In addition to the tax deduction, real estate has been historically proven to be an appreciating asset over the long term. For my rental property mortgage, I keep the balance as high as possible and pay it down as slow as possible.
- Business Car loan/lease – Buying a new car with financing or leasing one can be a poor financial move. However, if you use the vehicle primarily for your business, you can write off 100% of the lease payments, maintenance and registration. Purchasing a vehicle under your business will result in the interest cost, capital depreciation, maintenance and registration costs all being tax deductible.
- Student loans – Providing that the loans are federal/provincial and not a bank student loan, there is a tax credit applied against the interest paid. In addition, some provinces offer extra write offs for student loans. I would consider this borderline good debt but should be paid off after any bad debts below.
This is the kind of debt that you want to avoid at all costs as it will drain your cash flow, grow against you, and reduce your net worth. If you have this kind of debt, you’ll want to pay it down as fast as possible.
- Credit card debt – This is probably the most common type of debt held and among the worst. At an average of 18% interest, it takes merely 4 years for the balance to double. If credit card debt is a problem, read about how to get out of debt. One thing to try is to do a balance transfer to a lower rate card or line of credit. Some cards offer very low interest rates on balance transfers for an initial period.
- Pay day loans – I consider these stores/services legalized loan sharking and should be avoided like the mother in law (just kidding mum). I’m not sure how these stores stay unregulated as they charge ridiculous annualized interest rates as high as 300% to 1000%.
- Personal Car loan – Not only is the car depreciating at a sickening rate, there is non-deductible loan on the vehicle as well. Prioritize this as high on the list as debt to pay off ASAP.
- Principle Residence Mortgage – This is the lessor of all bad debts as it is a loan against an appreciating asset. This is not always the case however as even the real estate markets can tumble. A prime example is what’s happening with the real estate market in the U.S now. The biggest reason why I would put a principle residence mortgage slightly on the bad debt side is because the interest is not tax deductible (unless you live in the United States). On another note, there are ways to convert your bad debt mortgage into good debt as I’ve written about many times before.
For most, the ultimate goal is to eliminate all debt. However, if accelerated wealth is your goal, then one way to do it is to leverage and take advantage of other people’s money by maintaining your good debt while paying off the bad debt.