When good debt goes bad

The concept of good and bad debt is fairly straightforward: bad debt loses value, while good debt gains in value.

A large credit card balance, for example, is a bad form of debt because all those gadgets and groceries you paid for lose value the instant you leave the store. A mortgage, though, is good debt because you’re buying something that you expect will increase in value over time.

When the economy was booming, it was clear which debts were good and which ones weren’t. Student loans allow you to continue your studies, which, in turn, can help you get a better paying job; an investment loan can help you make more money when markets rise. But the distinction between good and bad debt may be blurring.

“The premise of good and bad debt is still the same,” says Laurie Campbell, CEO Credit Canada Debt Solutions in Toronto. “But in today’s economic uncertainty, all (good debt) could backfire.”

If things do backfire, the first casualties could come from the housing market. When interest rates rise many experts believe the housing market will fall—perhaps significantly. While it’s too early to tell what will happen and if it will affect every city the same way, the fact remains that sudden house price drops mean good debt could quickly turn bad.

Let’s say you have a $650,000 mortgage on a $750,000 house. If the value of that house fell by 20 per cent it would be worth $600,000, or $50,000 less than what you originally borrowed to buy the home. Over the long-term, housing prices could rise again, but if they don’t then you could be stuck with an asset that hasn’t changed in value or depreciated over time.

Garrett Sutton, a Reno, Nev.-based lawyer and author of The ABCs of Getting Out of Debt, says good debt is something that allows you to advance your financial goals. He’s seen first hand how good debt can turn into bad debt. Nevada has one of the highest foreclosure rates in the country. People there thought they were buying places that would make them money one day, but then the market crashed and their homes lost a lot of value.

These days there are “limited situations where you can have good debt,” says Sutton. Unfortunately, situations he identifies also involve risk. Buying a investment property, where there’s an expectation of regular monthly income, can be considered good debt. The same goes for owning a business that offers a stable income stream. Of course, businesses fail and rental properties need tenants, so there’s no guarantee that these things will be a good use of credit.

If you are looking for an example of a way to borrow that involves less risk then consider taking out a loan to invest in an RRSP. Campbell thinks this is a good use of debt, but only if the money is used wisely. Put the cash in a GIC, to keep it safe, she says. While a GIC will only give you a small return, you’ll get a higher tax refund. If you invest that refund back into your RRSP it will help boost portfolio returns over time.

However, it’s important to pay back the loan as soon as possible, ideally within 12 months. “If you have to pay back a $10,000 RRSP loan over three years are you really ahead?” she asks. “It’s hard to say.”

Even if the line between good debt and bad debt is narrowing, there are other reasons to buy a house or go to school than financial gain. Likewise, taking on bad debt can sometimes help you in other ways—most people need cars to get around.

Ultimately, in today’s economy, and with Canadians so heavily indebted, people need to be more aware of how their debt is working for or against them. “Debt is not a bad word,” says Sutton. “It’s allowed people to achieve their financial goals. But you have to be very cautious about distinguishing between good and bad.”

Originally published on moneysense.ca