Million Dollar Journey

Building Wealth through Saving and Investing

Welcome to Million Dollar Journey! If you're new here, you can learn about me, read our user guide, and even follow my net worth updates. A great place to start reading is with the popular articles located in the right side bar. If you would like to join thousands of others and keep up with the free daily updates, you can subscribe to the RSS feed via reader or E-mail.

On your way out, make sure to check out the exclusive Million Dollar Journey Freebies and Deals.

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!

Good 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.

This includes:

  • 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.

Bad Debt

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.





34 Comments, Comment or Ping

  1. Interesting – just to add one thing, I don’t think that categorizing debt into “good” and “bad” is really enough. For example someone who is in a 46% tax bracket will get more benefit from an investment loan than someone who is in a 25% tax bracket. So the investment loan debt is “gooder” for the higher income earner.

    Another factor is risk – any “goodness” from tax-deductible debt has to be reduced somewhat by the extra risk of having more debt. Someone who has a good financial situation can easily borrow smaller amounts with very little extra risk but if they borrow too much then the extra risk might outweigh the “good” aspect of the debt. Same thing applies to someone who maybe doesn’t have the best financial situation to begin with.

  2. Good post – to add, I do separate into three categories:

    Bad debt, Good debt and Best Debt

    Bad debt: loans used to buy depreciating asset

    Good debt: loans used to buy appreciating asset

    Best debt: loans used to buy appreciating asset and interest is deductible

  3. Great points there guys, some food for thought.

    FP, how much “good” debt do you feel comfortable with? Is there a rule of thumb or is it a personal choice?

    Preet, yours is a better way to structure debt. Simply having good and bad debt is a little broad isn’t it?

  4. 4. DAvid

    Frugal Trader,
    I believe you can only write off that portion of your vehicle expenses that are actually related to the business. Personal use such as traveling to and from work, personal errands, etc., must be cataloged, and excluded from the calculation.
    Thus, it really does not matter on a non-specialized vehicle whether you have a vehicle paid for by the company, and you use it for a small amount of personal use, or have a personal vehicle you use primarily for business, and claim mileage costs from the company.

    DAvid

  5. 5. dc

    FT – another point with respect to a vehicle for work purposes is that CCRA has limits on both the purchase price and lease payment that can be deducted. I would have to look to see what the latest limits are, but there is essentially a cap that prevents a person from “writing off” a luxury vehicle (or a vehicle with an excessive cost).
    As a specific example, a friend of mine works in the oilpatch and is required to provide his vehicle for work. Since he gets to deduct his costs, he went out and got the most expensive, loaded quad cab that he could find thinking he could “write it off”. When he did his taxes, he realized that less than half of his lease payment was actually deductable.

    Also, DAvid’s comment re: personal versus work milage is important to keep in mind. A lot of people don’t track this and end up at the mercy of CCRA when trying to defend what they have claimed.

    As a final point, I think that there are too many people making financial decisions by focusing too much on the tax impact. I always hear people saying “I can write that off” or “I need to bump up my expenses so I don’t wind up paying taxes”. I tend to hear this from small business owners/people in consulting roles. Cash is still cash. Cash paid for a business expense is still cash you are spending. I find it silly that people would incur an expense that was not otherwise contemplated just to save on taxes.

  6. dc, great points. Yes, DAvid is correct, personal use of a vehicle cannot be included in the tax deductible portion of the vehicle.

    With regards to the business expenses and increasing expenses to reduce taxes. The only way that I would agree to increase business expenses for taxation purposes is if the expenses was towards the growth of the business like increased marketing.

  7. FT – I don’t have any rules of thumbs, just musing in a general sense. My point was that ‘good’ debt for one persion might be ‘neutral’ debt for another person or even “bad” for yet another person.

  8. 8. Steve Heath

    Is it really tax deductibility that is the criteria, or is it the return? All tax deductibility does is lower the borrowing/purchasing costs, which, if returns are constant, boosts the profit. While that is definately a good thing, and if you are comparing two options, one with tax deductibility vs. one without, the former might be superior in most cases, but I don’t think tax deductibility can be used as a way to decide good debt vs. bad, rather, you have to net out the present value of all the returns and all the costs and determine if overall you are positive or negative.

    Even then, there are circumstances where using the return is inferior to assessing good or bad debt from a non-financial perspective. For example… someone having no liquid cash finds out their father is dying, and uses a credit card to fly out there to be with him during his final days. While financially it is a bad decision, since there is no financial return for the money, emotionally it might be money well spent for the person.

    I think ultimately, the greatest tool we have to decide between bad and good debt is our common sense…. unfortunately, as nationwide savings statistics indicate… it’s not too common :)

  9. 9. Al

    I tend to think of debt as always being bad, just a question of how bad. For instance credit card debt is super duper evil bad, while a mortgage is less so (but still bad, a necessary evil). Using debt to leverage investments is bad too. If you are using only a small amount of leverage, it’s hardly worth the hastle. If you go big you’re likely to be setting yourself up for a catastrophic event that will wipe out all your gains (a la Country Wide). My 2 cents.

  10. Al – I think you might have hit the leverage nail on the head. I do some leveraged investing but I’m not as crazy about it as I used to be. It is a bit of a hassle and there is extra risk. In my case I’m borrowing an amount that is quite manageable but as Al says – is it worth doing for smaller amounts? At this point I’m not sure if I want to add to the leverage amount so somewhere along the way I need to decide if I’m ok with a small amount of leverage or should I increase it? or just axe it altogether.

  11. 11. Telly

    I agree whole-heartedly with dc and DAvid. A loan-free car is a much cheaper after-tax alternative to leasing a vehicle. Even if you’re in a high marginal tax bracket (say 43%), your return only amounts to 43% of lease payment – the rest came out of your pocket.

    Increasing expenses to get a bigger tax return is surprisingly common but doesn’t make any sense. All the other good debts you listed should increase wealth but the business car loan / lease just increases expenses. It’s actually worse than the argument that Americans use to purchase larger houses – the interest is deductible. But if you don’t need a bigger house, what’s the point, more than 1/2 of that interest paid ended up coming out of your pocket?

    Sorry FT, I generally agree with you 99% of the time but the business car loan shouldn’t be considered good debt imo.

  12. 12. DividendMan

    The only good debt, in my view, is debt you take in order to make an investment that has (as evaluted under some reasonable method) a good chance of returning more than the interest incurred on the debt.

    If you needed to take a 10k cash advance on a credit card to secure a bid on some item you know you can make 11k on and repay the cash advance in a couple of days – that’s good debt.

    If you took a margin loan to invest in some speculative mining stock or something like that, I would still consider that bad debt.

  13. Great point Telly, I should have 3 categories instead of 2. The business car loan should be somewhere in the middle. The way that I look at a business car loan is that if it’s a necessary expense, which in turn helps grow the business, the tax deduction is an added bonus. Getting a car just for the sake of the tax deduction, without the potential of helping the business is a mistake.

  14. 14. mjw2005

    Even if you get a student loan through a bank its usually just prime +1 at least mine was….since education can lead to higher earnings in the future or at least a more enjoyable job and higher standard of living I would consider it good debt…

    Its difficult for people with assets and income to qualify for government loans for school…

  15. 15. that guy

    i think you understate the “goodness” of student debt. education is an investment. in fact most formal education (e.g., a university degree) has a solid return (6-10% per year in most academic studies, including all opportunity costs) and lower risk than other investments with similar returns (stocks, bonds). for the typical individual, human capital is their most valuable income-producing asset.

  16. 16. Start-Up

    I think the utility received from the investment has to be considered in general when calculating whether or not to take on debt. I think that a principal residence mortgage prevents you from paying money on rent, which nets you no future returns. Also, for personal cars, sometimes taking on debt is a must. If you need the car to get to work, you take on debt in order to make money and pay for necessities. This discussion should involve utility of the debt.

  17. 17. islander

    I have been following the MDJ for quite some time, great reading and threads to make a fella ponder. While i know this is a comment thread if I could be so bold as to ask a question. We have no debt other than a mortage (variable) (85k) and a secure LOC at prime (26k) that we used to by a piece of land. We have only have 10k in RRSP, bring in 110k/a gross but are in need of 1 maybe 2 vehicles. Our goal, like everyone else’s is to amass wealth. Would it benefiet us more to save all extra $ for vehicles, pound money to the LOC and pull it back out for tax deductible investments or manage the vehicle payment and LOC while keep contributing to RRSP? and I have not even mentioned pounding away at the mortage.There are so many scenarios to consider, and while most are positive in my mind, is their weight to any of them that should be considered in our decision making?

    I would ask my adviser but he suggested leveraged investments a while back with the comment “when is the last time you saw a bank lose money?” I get the feeling he just wants the commission off my debt.

  18. 18. Sarlock

    RRSP, hands down. Your mortgage and LOC are at a low rate, I would just let them burn down at their regular amortization rate. You should have a lot more in RRSPs at your income level. If you find yourself with extra cash after putting a hefty amount each year in to your RRSPs, then you’re in a great position to strategize how you spend your remaining dollars.

  19. 19. Jon Kepler

    I’d argue against a personal car loan being a “bad” debt in certain situations. Why pay cash when you can get a loan at anywhere from 5% right down to 0%? Also, since business was mentioned, all debt should be compared and contrasted to the sometimes-horrific alternative: selling business equity.

  20. I would echo what that guy said about student debt- many educational credentials can exponentially increase your earning capacity

    As mjw2005 pointed out, it really doesn’t make a lot of difference whether the debt is by was of Canada Student Loans or private loans, as fed/prov loans have an interest rate of prime + 5% (fixed) or prime + 2.5% (floating), whereas private students loans or lines of credit can have rates as low as prime (I’ve yet to see any discounted below prime) or prime + 0.5% / 1%. Even after the tax implications, there is little difference between the net amounts paid. The biggest benefit of a Canada Student Loan is that repayment is very flexible and can be modified ad infinitum.

  21. 21. Al

    islander,

    As a rule of thumb, always put your money on the highest interest rate whether it’s investing or paying down debt. You have to take taxes into account of course and not all investments have a clear rate of return, so it’s not always a simple rule of thumb to apply.

  22. 22. CT

    I agree with Jon Kepler.

    My fiancee and my sister both bought new cars within the last year. Although reluctant, I managed to convince them to take low interest (0% and 0.9%) financing on their purchases (rather than paying cash) and put the money into their mutual funds or a high interest savings account instead.

    Is there some downside that I don’t see? Is this still considered bad debt?

  23. 23. Ed Rempel

    Hi CT,

    The issue with low rate car loans often is that extra cost has been built into the price of the car. If you could have bought at a lower price with cash, then the difference in cost is really extra interest.

    Also, low rate car loans are generally only available on new cars. You can usually save far more money by buying used, even with normal car loan rates. A 2-3 year old car is usually only half the cost of a new one. It it because of the high cost of depreciation in the early years (and to get warranty work) that car companies offer the low rate loans.

    Ed

  24. 24. Ed Rempel

    Good article, FT. I agree with Preet and his 3 categories of debt. Debt is only “good debt” if you are better off having it than not having it. This would only include debt for effective investment.

    A leverage loan that is invested effectively for the long term is good debt. You could sell some investment to pay it off any time, but if you are confident in a good long term return on investment and your debt is a low tax-deductible rate, then you are better off having the debt and keeping the investments than selling some to pay if off.

    Getting a tax deduction on its own is not enought to make regular debt “good”, since you would still be better off without a business car loan or student loan.

    Ed

  25. Hi Ed,

    A 2-3 year old car doesn’t necessarily offer the savings or value that many people expect. While it’s true that a new car depreciates the most in its first year (usually 20-30%), you continue to see steep depreciation (15%+ a year) in the first 5 years of ownership. In some ways, a 2-3 year old car can be the worst of all worlds- you don’t get the choices/customization, full warranty, or sale incentives of a new car (or that oh-so-elusive new car smell!), but you still get the heavy depreciation. If you’re looking to avoid taking a big depreciation hit, you need to look at cars a fair bit older.

  26. 26. Cannon_fodder

    dc,

    The CRA limits the leasing costs to $800/month (plus GST/PST), the interest costs at $3,650 (assuming you took out a loan to finance the purchase) and the Capital Cost maximum is (still!) only $30k.

    I will need to get a new vehicle soon (mine is 13 years old) and based on my driving and tax rates it would seem I’m best to lease a quality vehicle and then, once the lease expires, purchase it at which time it should be less than $30k.

  27. 27. Cannon_fodder

    Dividendman,

    I agree. If someone could loan me $10M at prime, I could invest it in the Canadian stock market and retire right now – and still sleep at night!

    While the potential for gains and losses is magnified the more leverage you have, the inherent standard deviation of the investments’ prices are not affected – thus, this measurement of risk is not dependent on how much you leverage.

    There is additional risk by leveraging more if your cash flow can’t handle it. Investing in dividend producing equities which can cover your interest costs helps mitigate this risk.

  28. 28. Cannon_fodder

    Moneygrubbinglawyer,

    I would imagine a 5 year old car, especially in this environment, will be much harder to find someone willing to lease it to you thus limiting your options.

    I think a 3 year old vehicle is a nice sweet spot – usually there is still 1 year of warranty left, it still is new enough to have most of the latest safety features (extra airbags, dynamic stability control, etc.) and should be relatively reliable with a good chunk of depreciation already absorbed by the previous owner.

  29. Interesting article! This information would definitely help individuals in determining what kind of debt to avoid accumulating. The current economic meltdown and the soaring amount of insolvencies this year is a clear indication that a people need quality advice on how they can have a fresh start and live free of debt.

  30. 30. cannon_fodder

    I finally broke down (once I realised the federal government wouldn’t take a recommendation to heart and offer a cash incentive for people to replace aging cars with new ones) and retired our 14 year old vehicle.

    I ended up getting a 4 year old vehicle that had a bigger engine, was a convertible, had more safety features, better list of standard equipment, etc., etc.

    And you know what? It cost about the same as when I purchased the similar vehicle (brand/model except for the convertible/coupe portion) as when I bought the a 3 year old version of it 12 years ago! And this was NOT factoring inflation into it. With the low interest rates, my financing terms mean it will actually cost me less.

    It is truly amazing how little car prices have actually risen. I can get so much more car for a lot less (in constant dollars) than what I paid 12 years ago.

  31. Great article with some very interesting points! This is the kind of information people need to keep in mind in order to avoid accumulating bad debt. The concept of good vs bad debt will definitely clarify any doubts on how people can manage their finances better.

  32. 32. Toronto Bankruptcy

    This is a good and concise article. Given the current recession, the perception in the public at large is that ALL debt is bad debt. This of course is not true. Thanks for pointing this out in your article.

  33. 33. djia futures

    Too many people forget that credit score is based on debt and how it is paid. Having maxed out credit cards is the WORST kind of debt. If you make the minimum payments, then you could be paying for years and years (just because you could not wait to buy that new HDTV). I can understand having a credit car for emergencies, like if your car breaks down unexpectedly (I guess that is redundant Ha/ha), but it should not be used to go on shopping sprees.

  34. No such thing as good debt, it is simply a rationalization for having to borrow to get what you want. There is less bad debt, but calling it “Good” is a dangerous rationalization.

    Trackbacks

Reply to “The Difference Between Good Debt and Bad Debt”

Subscribe without commenting



Get the Latest

      

Money Tips Newsletter

Premium Sponsors



Recent Comments

  • FrugalTrader: @JT, we paid off the instalment portion of our mortgage a few years ago. The dividends are reinvestd in...
  • JT: Just to confirm; you are using the approx. $5,600 in annual dividends to pay down your existing mortgage and...
  • Ed Rempel: Hi Mark, An important question in this debate is: Is it a good idea to pay off your mortgage early? I have...
  • Ed Rempel: Hi Mark, I think you are missing the mark. (Pardon the pun.) From working with thousands of people and...
  • R: “Guaranteed by the government ” is baloney. Somebody flies a jet into a skyscraper and all of the...
  • Hemgi: If you can get a RRSP return on investment over 6%, or a TSFA return on investment, then you can think of not...
  • Cashinstinct: We invest with DCA in index funds to avoid trying to time the market, each month some money goes from...
  • My Own Advisor: @cashinstinct, nothing wrong with your plan, it sounds great actually, the long-term equity SHOULD be...
  • SST: Clutter is also cognitively exhausting, thus perhaps resulting in poor investment decisions = even more money...
  • My Own Advisor: @Ed, no cop-out here. What I’m saying is, I don’t feel there is a clear winner for most...
 css.php