With all the dire warnings from policymakers these days about household debt levels, it is easy to see why debt is considered a four-letter word.
But there is good debt and there is bad debt – and it is important that consumers differentiate between the two, says certified financial planner Russell Nagano, a partner at Toronto-based CCG Personal Wealth Management.
Credit card splurges to satisfy the gotta-have-it itch clearly fall into the bad debt category if they are not paid off immediately or the cards carry high interest rates, financial planners say.
Mortgages, which account for the bulk of Canadian household debt, are generally regarded as good debt because real estate appreciates over the long term, says certified financial planner Tina Tehranchian, branch manager with Assante Capital Management Ltd. in Richmond Hill, Ont.
Home equity loans, with their enticingly low interest rates, come down on either the good or bad side of the ledger depending on what they are used for and how diligent the borrower is about repayment.
“You wouldn’t recommend it for someone who is undisciplined, because you could have that line of credit and just run that up as well,” says Al Nagy, an Edmonton-based certified financial planner and regional manager at Investors Group Financial Services Inc.
Debt can be a useful tool when invested in something that grows in value, while bad debt is money owed on a loan used to buy something with depreciating value or “debt that you can’t afford,” Mr. Nagano says. And even if you can afford the debt servicing costs now, it’s prudent to factor in the potential impact of higher interest rates in the future.
“My advice to clients is when you borrow to invest, always make sure you can afford that loan, even if interest rates go up another three percentage points,” Ms. Tehranchian says.
Here are tips on distinguishing good debt from bad:
RRSP loans: “Very popular at this time of year,” Mr. Nagy says. “Again, it should be recommended for someone who is disciplined. If you take out an RRSP loan, and take the tax refund that the RRSP contribution is going to generate and apply it to the principal of the loan, the debt is paid off more quickly. It’s a great strategy.” Ideally, the RRSP loan should be paid off in one year or less, Ms. Tehranchian adds. “You do not want to carry on an RRSP debt for five years. I know there are banks that are offering five-year RRSP loans, but that does not make much sense.”
Borrowing to invest in the stock market outside of your RRSP: “Risky in that it is an aggressive strategy – you can magnify your gains and you can magnify your losses,” Mr. Nagy says. “You certainly would not do that strategy for the tax deduction [on the interest for such loans], although that is a benefit. And you would certainly have to, in the planning process, identify that borrowing to invest will increase net worth in the long run. If you can show that, and if it is in the individual’s comfort zone, it may be a good strategy.”
Car loans: Not so good, because the value of the vehicle depreciates, but necessary for most Canadians, says Ms. Tehranchian, who suggests that consumers pay cash if they can.
Another strategy for people who do have cash on hand – and in this environment of zero-per-cent car loans – is to take the interest-free financing and apply the gains on personal investments to paying off the principal, Mr. Nagano says. “In other words, if they had $40,000 for a car, but they could borrow at zero per cent, then we would put that forty grand in a separate account, invest it usually in a conservative portfolio, and do an automatic withdrawal through their bank account . . . to make their car payments. And at the end of that five years there’s going to be a balance left because it [the investment return] is going to be better than zero per cent,” Mr. Nagano says.
Student loans: For the most part, good. The investment in education ultimately pays off in higher earning power, which, in turn, contributes to increased personal net worth, Ms. Tehranchian says. “But you have to be very careful in terms of the field of study. ... You may sink thousands of dollars into a degree and, at the end of the day, find it does not have the income potential that you thought.”
Credit card debt: “There is nothing evil about credit cards by themselves,” Ms. Tehranchian says. “Credit cards can be a great convenience.” But if the repayment burden is weighing you down, Mr. Nagy suggests looking at a loan consolidation strategy. “If you own a home, you can consider consolidating your debt through a home equity loan. ... You can pay a much lower interest rate than you would on your credit card, which could range from 19 per cent to over 28 per cent for a retail card,” he says.
The bottom line: A comprehensive approach is key. “You see people who have credit card loans that they are paying outrageous interest rates of upwards of 20 per cent on, and at the same time they are keeping cash in the bank or Canada Savings Bonds with paltry interest. It makes them feel good [to have cash in savings], but your net worth is still negative if you have more debt than you have cash in the bank.”
By the numbers
50%: Proportion of Canadians who think reducing debt is a high priority
48%: Share of Canadians who would have difficulty making mortgage payments if interest rates rose significantly
43%: Proportion who carried over a balance on their credit cards
17%: Share who had borrowed to cover day-to-day living expenses
Source: Canadian Institute of Chartered Accountants surveys conducted in December and June, 2012