Many people have grown up with the idea that all debt is bad and to avoid it whenever possible. However, this is simply not the case. By successfully leveraging good debt, you can increase your net worth. You will also improve your credit score. This can in turn lead to better mortgage rates, lower credit card payments, and more money-saving perks.
There is a big difference between good and bad debt. It is important to recognize this difference before you go on a borrowing spree. Simply put, good debt is what people take out to increase their assets or net worth. Whereas bad debt is what people take out to purchase something which will rapidly depreciate in value. For example, if you take out a mortgage to buy a home, the loan is a good debt. This is because the property will accrue additional value down the road. On the other hand, taking out a loan to buy a car is usually a bad debt. This is because the vehicle’s value will deplete incredibly fast. If you want to build your wealth, it is important to avoid bad debt whenever possible.
As we have mentioned above, auto loans are a notorious type of bad debt. According to Statistics Canada, the average car loan in July 2022 had an interest rate of 6.62%. Though, depending on the credit score and issuer, your auto loan may have a far steeper rate. Unfortunately, you cannot count this as a smart investment. Many vehicles can lose up to 40% of their value in the first year. Plus, the average auto loan has a 6-year term, so it will be draining money for years to come.
Of course, cars are still a useful (and in many situations, indispensable) method of transportation. But taking out a high-interest loan on an item with depreciating value is a sure-fire way to get into bad debt. By the time that you have paid off your new car, it will be worth thousands of dollars less. Instead, consider buying a used car to minimize depreciation.
Buy Now, Pay Later loans
Buy Now, Pay Later loans can be a major help if you cannot immediately afford to pay for a purchase. They generally allow you to split a single large purchase into four smaller, 0% interest payments. The issuer then charges the payments to your credit card every two weeks. Each Buy Now, Pay Later company works slightly differently. Afterpay will put your account on hold if you miss an Afterpay payment. However, Afterpay does not charge Canadian borrowers any fees. If you miss a Scotiabank SelectPay payment, the instalment plan’s entire outstanding balance is added to your credit card statement. This leaves you vulnerable to interest rates.
Buy Now, Pay Later loans may not have particularly high fees. However, people often use them for rapidly depreciating products. Most establishments that offer Buy Now, Pay Later financing sell consumer goods. Such as clothes and home goods that you could easily overspend on. It may be smart for a budget-strapped remote worker to use Buy Now, Pay Later to replace a broken computer. In comparison, the same is not true for their shopaholic fashionista friend. Most consumer goods rapidly depreciate in value after the purchase. Hence, taking out a big loan to buy $500 worth of clothing is the epitome of bad debt.
Payday loans are notorious, and for good reason. Their high fees vary by province, but may reach up to $25 per $100 borrowed. This equates to a 650% annual interest rate, and that is before you begin to factor in late penalties and interest rates. Plus, payday loans have a ridiculously short term. Several provinces (Alberta, British Columbia, Manitoba, Ontario, and New Brunswick) have laws in place that give borrowers 62 days to pay back payday loans. Otherwise, Payday generally requires you to pay the loan back from your next pay cheque. As a result, it is easy to end up in a vicious loop where you miss payments. This can lead to increasingly high fees and interest rates. Long story short, payday loans are not worth it.
While Buy Now, Pay Later loans are making it easier to finance retail purchases, many stores also offer some form of traditional in-store financing. Generally, this means that a store partners with a financial institution that processes the application, signs a contract with you that specifies a loan term, and pays the store on your behalf. Then, for the next 3 to 36 months (exact terms vary by store and provider), you will be on the hook for monthly payments.
Unfortunately, while Buy Now, Pay Later programs have low fees, traditional in-store financing is not as generous. Exact numbers vary by retailer, but you can expect annual interest rates to range between 30-38%. Make sure to read the fine print, too. Some in-store financing options offer a 0% introductory promotion rate. But beware, this usually only lasts for a small fraction of your loan’s term.
Credit card debt
Loan types are not intrinsically bad, and you can leverage most towards good debt purchases. However, some forms of loans are much easier to abuse than others and can quickly lead to bad debt.
Unfortunately, since credit cards are so easily accessible and have high interest rates (regardless of whether or not you have a secured credit card), it is incredibly easy for your next credit card purchase to turn into bad debt. Generally speaking, consumer goods lose their value very quickly, but most credit cards have an annual interest rate of around 20%. Even if you use a low-interest credit card, failure to pay the card off in full every month will leave you with an ever-increasing bill and a purchase that is likely worth a fraction of what you originally paid. This is a terrible way to waste money, not to mention a prime example of bad debt.
Line of credit debt
Money that you borrow via a line of credit is not always bad debt, but it is easy to use the money foolishly. Although line of credit interest rates vary from month to month (and will be impacted by your credit history), you can generally secure a line of credit with an annual interest rate of around 3.5-6% if you own property. In most cases, you can then take as long as you would like to pay back the loan. Though you will have to pay off the interest every month (and some providers may have stricter repayment rules).
With such a low average interest rate, a line of credit could theoretically be utilized as good debt. For example, if you use money from your line of credit to renovate your home and thus build significant equity, you will have ultimately made money. However, if you wish to use the money to purchase consumer goods that will depreciate in value, you have entered the territory of bad debt once again.
Frequently asked questions about bad debts
Do you still have some questions about bad debt? Check out our list of frequently asked questions for help.
Debt consolidation is a helpful tool that can make it simpler to pay back multiple credit accounts. Depending on your debt consolidation agreement, you may even be able to enjoy a lower interest rate, ultimately saving you money in the long run. However, while debt consolidation can potentially eliminate your bad debt’s high interest rates, it will not turn your bad debt into good debt. You should also know that debt consolidation may have an impact on your credit score.
A bad debt expense is anything that you purchase via some sort of high-interest loan, despite the fact that the item itself rapidly decreases in value. For example, auto loans and credit cards typically have very high interest rates but are predominantly used to buy goods that quickly depreciate in value.
That being said, in order for an item to be considered a bad debt expense, you must be losing money on it. If you are starting a heavy-duty cleaning business and purchase a van to transport your supplies, that van would be considered a good debt expense since it will enable your business to make money in the future (regardless of the fact that the vehicle’s value will depreciate).
A mortgage is not considered to be a bad debt because it is used to purchase an asset that will ideally appreciate in value, leading to a net positive in most cases.
Most Buy Now, Pay Later loans are considered to be bad debts. While you could technically use such a loan to buy an asset which will appreciate or generate revenue (i.e. business supplies), thus making the purchase a good debt, Buy Now, Pay Later loans are often associated with purchasing apparel or home goods—both of which quickly depreciate in value.
If you are going to make a good debt purchase, a Buy Now, Pay Later loan may be the smart choice if you would prefer to retain some cash upfront but know that you can make the install payments by each deadline. This will effectively allow you to enjoy a highly competitive 0% interest rate. However, if you are not sure that you can pay each installment on time, you should consider other loan options.