Good Debt vs Bad Debt

There is no easy answer, but here are some factors to consider when making decisions about taking on debt:

Features of Good Debt

Good debt is generally going to be borrowing that helps you build long-term financial stability, increase your earning potential, or acquire an asset that is likely to appreciate in value over time. It is debt borrowed with a purpose and a reasonable expectation of future financial benefit.

Some examples:

Mortgages 

Not many people can buy a home outright with cash. Purchasing a home typically requires borrowing a significant amount of money. While a mortgage creates a substantial financial obligation, homeownership can help build equity over time. Although property values are never guaranteed to rise, real estate tends to increase in value over time. If the value of the property increases at a rate that is higher than your mortgage’s interest rate, you may come out ahead. But don’t forget to consider other costs of owing the property, such as property taxes and upkeep.

Student Loans

Borrowing to pursue post-secondary education or professional training may improve your employment opportunities and future earning potential. If the increase in your earnings ends up outweighing the cost of the education (including interest on your student loans) it is usually a good investment, as long as you can afford to service the loan while your new career is getting started. However, changes to the economy can impact career prospects, so there are never any guarantees the cost of the education will be worth it, especially these days with the uncertainty around the impact AI will have on jobs.

Business Loans

Borrowing money to start or expand a business can be a productive use of debt when the funds are invested in equipment, inventory, or other opportunities that generate revenue. As long as the revenue generated is sufficient to repay the debt (and interest) , plus some upside, it's often worth taking on debt. Of course, there is always risk in business, so the potential payoff needs to be worth taking on that risk.

The common thread when it comes to these examples of good debt is that good debt has a clear purpose and the potential to improve your financial position over time, even after the cost of the debt is factored in.

Features of Bad Debt

Bad debt generally refers to borrowing that doesn’t provide any benefit. Often, debt is used to purchase things that either lose value quickly or provide insufficient long-term financial benefit to justify the cost of the debt. The higher the interest rate, the higher the overall cost of the debt and the higher the ongoing payments. Sometimes this means that keeping up with debt payments requires more ongoing borrowing to cover everyday expenses.

Some examples:

Credit Card Debt for Daily Expenses

Credit cards can be a convenient way to purchase things and are highly effective at building a strong credit history when used properly. To use them properly, however, they need to be used sparingly (ie. never using the full amount of credit available) and be paid in full each month. On the other hand, carrying balances from month to month is expensive because of the high interest rates most cards carry. Therefore, accumulating credit card debt to pay for groceries, utilities, or other necessities makes those necessities even more costly. This is why needing to use credit to cover necessities is a warning sign of financial difficulty.

Payday Loans

Payday loans are generally short-term, very-high-cost loans intended to bridge the gap between paycheques. They can provide temporary relief when no other options are available, but their high borrowing costs can make it difficult to repay the original loan without taking on additional debt. And typically if a person takes on a payday loan to fund an expense they cannot otherwise afford, they struggle to get out of the cycle of re-borrowing each payday, meaning the high fees add up over time to significantly impact finances.

Personal Loans for Non-Essential Purchases

Personal loans sometimes have a lower interest rate than credit cards, making them an attractive alternative. However, borrowing money to finance vacations, electronics, entertainment, or other discretionary purchases creates financial obligations that often last long after the enjoyment of the purchase has passed. And if it takes a long time to pay off the loan, the interest costs can add up to make the original thing you purchased much more expensive than it seemed at the time.

The problem with bad debt is not necessarily the type of credit or what you purchased with it.  It is the combination of high borrowing costs, inability to afford the thing purchased, and the lack of any lasting financial benefit that make some borrowing a bad decision.

When Good Debt Becomes Bad Debt

Even types of debt that are traditionally considered good debt can become overly burdensome when circumstances change. For example:

• a mortgage may have looked like a good investment when you purchased your home, but the housing market can weaken leaving you with more mortgage than property value. And if you can't afford the monthly payment, it doesn't matter if the decision looked good on paper. Even monthly payments that seemed affordable in the beginning can become difficult to manage if you experience a job loss, separation, illness, or increase in household expenses. 
• a student loan may have been a reasonable investment in your education, but if your expected career opportunities do not materialize for any reason repayment may become challenging.
• borrowing to expand a business may make financial sense when sales are growing, but declining revenue, business interruption, or unexpected expenses can quickly turn business debt into an anchor weighing the business down.

Ultimately, whether debt is good or bad depends on the value it can produce as well as your ability to manage it and repay it without compromising your overall financial well-being.

Five Questions to Ask Yourself Before Taking on Debt

Taking on debt without stepping back to consider all of the pros and cons can lead to bad decisions. Before borrowing money, we recommend you take a moment to consider the following questions:

1. Do I really need to borrow? Could you save for the purchase instead of financing it? Using cash for the purchase lowers the overall cost of the thing you are purchasing, because you avoid adding interest charges to the equation.
2. Can I afford the payments? Lenders will often qualify you for a loan based on your income. But you need to also consider your other financial obligations – those that exist now and those that are likely to come up while you are still paying off the loan.
3. What is the total cost of borrowing? Look beyond the monthly payment and consider interest rates and fees that will be included in the total amount you'll repay. Lenders sometimes make a loan seem affordable by advertising a low monthly payment, but that low monthly payment often masks the fact that you will pay significant borrowing costs if you pay within that timeline.
4. Will this debt improve my financial situation? Consider whether the purchase or investment provides lasting value or future financial benefits. If not, you are basically asking your future self to pay for something that you will no longer be benefiting from.
5. What will happen if my circumstances change? Consider whether you could continue making payments if your income decreased or unexpected expenses arose. Borrowing up to your maximum limit leaves you no room for error. When something goes wrong, you won't want debt worries to add to your stress.

What To Do If Your Debt Has Become Unmanageable

Even responsible borrowing can lead to financial difficulty. Unexpected life events coupled with rising living costs and income that can’t keep up are situations we see every day.

Part of using debt responsibly is continually assessing whether your current debt load is still manageable. If you find yourself with unmanageable debt (see this blog post for signs your debt is unmanageable), the responsible next step is to get informed about the options available. Depending on your circumstances, solutions may include budgeting changes, debt consolidation, a debt repayment plan, a consumer proposal, or bankruptcy.

The best resource for information about your options is a Licensed Insolvency Trustee (LIT). An LIT is a highly trained government-regulated professional legally required to review your specific financial circumstances and explain the options available to you, helping you understand the advantages and disadvantages of each approach based on your unique situation.

There is no catch-all definition of "good debt" or "bad debt". The purpose of borrowing, the cost of the debt, your ability to repay it, and the impact it has on your financial well-being all factor in. Borrowing can be a useful tool when used responsibly and carefully, but taking on too much debt can limit your financial freedom and create unnecessary stress.

Charla Smith & Company Ltd. Is a Calgary-based Licensed Insolvency Trustee. We offer free no-committment consultations to review your financial situation and explain your options for dealing with overwhelming debt. Reach out for a free consultation.

Disclaimer: This publication was initially drafted with the help of AI but has been reviewed and heavily edited by an actual Licensed Insolvency Trustee based on their knowledge, experience, and independent research. This publication provides general information and should be seen as broad guidance only. The information contained herein cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon this information without obtaining specific professional advice relating to your particular circumstances. Charla Smith & Company Ltd. does not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.