Good, bad debt different
It's not hard to find a headline through social media warning of the high levels of household debt in Canada. Interest rates have been kept low deliberately in an effort to support the economy through the pandemic and Canadians have taken advantage of this new financial environment. We have, for the most part, embraced our credit and have made great efforts to reduce our personal debt in an attempt to strengthen our overall financial position. Today, Canadians owe approximately $1.63 for every after-tax dollar that they spend. You may think this is a high amount that demonstrates our propensity to reach for credit on a regular basis, but it is not. We have brought this number down considerably in the last 18 months with it being $1.97 for every tax dollar earned in 2019.
There is a difference in the type of debt you hold, and although it would be great to be wealthy and debt-free, you should remember that debt is also a tool to make you wealthy. When I was an adviser to very high net worth clients who had millions to invest, they, too, also had debt, but it was used to increase their wealth not to spend on more depreciating assets like cars, boats and toys. Instead, they would use debt to leverage and purchase stock or investment properties; basically spending this debt on any appreciating asset that would give them a higher rate of return, and in most cases a tax writeoff from the interest on the borrowed funds.
Most Canadians feel that debt is a bad thing, and many feel nervous when thinking about going into debt to make money. However, the vast majority do just that. We use debt for home and auto financing, home improvements and education. Debt that advances a person's ability to purchase assets such as homes, vehicles or investments, or is used to increase their income through business or education, is good debt. Many advisers would agree that these expenses are inherently appropriate today, and it is important for us to focus on what these borrowed funds will allow the household to achieve and if they will enhance wealth in the long run.
Bad debts are loans that do not advance wealth or income prospects, but instead provide enjoyment and an increased standard of living that cannot be supported by earnings alone. This would include things like balances on unsecured lines of credit, credit cards, or personal and consolidation loans. Some borrowers create a habit of using credit to fill in the gaps in their earnings, believing that they cannot survive on their income alone and need the credit to increase their standard of living. This type of borrower has the greatest risk today, even in a low-rate environment. They sometimes feel that they just can't earn enough for their lifestyle, but in reality they are just living above their means, unwilling to sacrifice more and get out of their comfort zone to make changes to better their situation.
These borrowers would indeed be in a vulnerable position if there were any disruptions in their income or if the interest rates started to climb (which they will). This habit must be broken to ensure you do not become a chronic borrower with a lifetime of debt. If this is you, or someone you know, try establishing a new financial plan to make the necessary changes you know you must to live on a budget. Devise a strategy to put your debts in order to create a stable financial future.
We must not forget that the low interest rate environment will not last forever and we should never become complacent about our debt — good or bad. You should always have a strategy to repay each debt in full during the life of the asset or at least by retirement. Always be planning. You can't expect to have a future if you don't plan for one.