Listen to the Podcast: Good Debt Vs Bad Debt. Experts Weigh In.
Doug Hoyes: Welcome to Debt Free in 30 where every week we talk about debt, money and personal finance. I’m Doug Hoyes. So here’s a question for you, is there such a thing as good debt? If you ask financial advisors that question they’ll give you a variety of answers.
One school of thought is that all debt is bad. With debt you pay interest which increases the cost of whatever it is that you financed. So the best strategy, they say, is to save money first then buy what you want with cash so that you get the best deal and don’t pay any interest, makes sense. As a side benefit because you have no debt, you’ll never go bankrupt because bankruptcy only happens to people who have debt. I’m a bankruptcy trustee so if everyone stopped borrowing I’d be out of business because they’d be no more bankruptcies. I’m not sure if I like that concept or not.
The other school of thought is that there is good debt and bad debt. Good debt is any debt that can be used to increase your wealth. The best example would be a mortgage which is debt you incur to buy a house. You borrow money to buy the house and you pay interest so you end up paying more for the house than if you bought the house for cash. But over time the house increases in value and so in the long run you’re better off financially because you financed a house. In fact, without a mortgage could any of us afford to buy a house?
My wife and I have owned a few houses and I know we didn’t pay cash for any of them. We always had a mortgage because that was the only way we could afford to buy a house. That’s the opinion of Pat Foran, the CTV television’s consumer reporter and author of many books including his latest, “The Smart Savvy Young Consumer.” In chapter 15 of that book he talks about good debt versus bad debt.
Pat Foran - Cautioning Young People About Good and Bad Debt
I wanted to hear his thoughts so I called him up and asked him if there really is such a thing as good debt or would it be better for some people, and particular young people, to avoid debt all together? Here’s what he told me.
Pat Foran: Yeah, well I think that these days it’s pretty much impossible to live without having some debt, especially a mortgage. I think what I was trying to say in the book to young people is that they should know that there is a difference between good debts and bad debts. And whenever I go out to schools I talk to them about, you know, is borrowing money to buy a house good debt or bad debt? Well I think that’s good debt, you’ve got to live somewhere anyway. You know, is borrowing money to go to Cancun for two weeks good debt or bad debt? And they’re pretty quick to figure out that that’s bad debt. You should just come home and you just have a bunch of pictures from a trip.
And then there are areas that might be a little more grey, you know, making a stock investment. Well that can be a good – that can be good debt or it can be bad if it goes south. So I think there are different examples of good debt and bad debt that young people should think about early and – so I think, yeah, that there are cases of good debt and bad debt. And young people can learn about them and think about them and just be cognizant about it. It’s good for them.
Doug Hoyes: Do you worry about what the real estate market is doing these days, particularly in Toronto with it being, you know, potentially over-inflated? Do you worry that getting - even though a mortgage is good debt, buying a house today, you know, could end up being a bad investment or do think that’s probably not a big worry?
Pat Foran: Oh, no I think it’s a very legitimate worry and I’m worried for young people today. Things are tough for young people today, finishing school, having a school debt, maybe not making as much money as people may have years ago. And then, you know, having to look to buy a house which is going to cost them. In Toronto they’re saying the average house is almost a million dollars.
So yes, I’ve already interviewed someone who’s concerned about the condo market in Toronto and I believe there’s going to be a correction underway in the condo market. I would be very concerned for anyone, you know, leveraging themselves too much and buying a condo that might be on the edge of their expenses. And the other thing too, is that some condo companies are now throwing in all kinds of things to try to get people to buy. But maintenance fees are also going through the roofs.
And then – actually I just had an e-mail from an older person today that they were just slapped with a twelve thousand dollar fee on their condo because they have to get the balcony repaired. I mean what can a young person do? Certainly I live Aisle 5 - I live in the outside area of Toronto. Maybe you have to start with a townhouse or something like that. But certainly I think many people are concerned that the housing market is over-valued because the homes are going for over-asking now and I just don’t know how long that can continue.
Doug Hoyes: That was Pat Foran, CTV television’s consumer reporter and author of many books. Pat knows a lot about personal finance and I think he has a very balanced view of the issue that we’re talking about today, good debt versus bad debt. He believes that, as he said, it’s pretty much impossible to live without having some debt.
How can someone just starting out possibly buy a house? Even if it’s a small condo in a small town, who can save one hundred and fifty thousand dollars? And if you want to buy a small condo in a big city like Toronto, forget it. It may take you decades to save a few hundred thousand dollars to buy that house. That’s why people tell you it’s better to get a mortgage because then instead of paying rent, the money you would have paid in rent goes towards the mortgage. If you own you don’t pay rent, so all of your housing dollars goes towards your mortgage. That also makes sense, but as they say, the devil is in the details.
If you make $3,000 a month and rent costs $1,000 a month, you’ve got $2,000 a month for other living expenses and savings. That sounds like a comfortable life to me. If you make $3,000 a month and you’re paying $2,000 a month on your mortgage and property taxes and condo fees, and house insurance, you now only have $1,000 a month to live on. That sounds very stressful to me. That’s what they mean when they say you are house rich, but cash poor. It’s great to own a house, but if you have nothing to live on is that a good plan?
So is a mortgage good debt or bad debt? It depends on your cash flow and your unique circumstances. It’s not a simple question. I’ve got other experts who have some thoughts on this topic, so let’s take a quick break and return and continue to answer the question. Is there good debt or is all debt bad? We’ll be back after the break. You’re listening to Debt Free in 30.
Robert Brown: Extending The Definition of Good and Bad Debt
Welcome back to this special edition of Debt Free in 30 where we’re discussing good debt versus bad debt. Is there really such a thing as good debt or is all debt bad? For another viewpoint I’ve invited back to the show, Robert Brown, the author of “Wealthing Like Rabbits.” It’s a great personal finance book. If you didn’t hear my original interview with Robert you can find it on I-Tunes or go to Hoyes.com and search for Robert Brown or “Wealthing Like Rabbits,” which is the name of his book. It would show number 14 where we covered a lot of topics so it’s worth a listen. Robert, welcome back.
Robert Brown: Thanks for having me Doug.
Doug Hoyes: So in your book you discussed good debt versus bad debt. So tell me your thoughts. Is there such a thing as good debt or is all debt bad? I mean as a bankruptcy trustee, I’m sitting here thinking well you know what? If you never had debt you’d never get into trouble, you’d never have to go bankrupt so I can certainly make the argument that all debt is bad, it’s cut and dry, really simple. What do you think?
Robert Brown: Well traditionally good debt is described as something – it’s money that’s borrowed to buy something that’s going to appreciate in value like a mortgage on a house or something that’s going to grow in its value. You say you’ve taken on the debt for good reason. Bad debt is money that is borrowed to buy something that’s going to depreciate in value like consumer goods or going to a restaurant, that’s bad debt. But it’s important to understand that not all good debt is good and not all bad debt is bad.
Now this is going to get a little wordy. You can have bad, good debt if you go out and buy a great big house that has a great big mortgage. That house will likely appreciate in value over time and technically that makes the big mortgage good debt. But it’s unlikely that it’s going to appreciate enough to cover the costs of the interest you will pay on the mortgage let alone the larger expenses that great big house is going to generate. Therefore, the good debt is bad debt. It becomes bad, good debt.
On the other side of that coin, Doug, if car unfortunately breaks down and you have to go out and get a two year loan to go out and buy a two year old Honda Civic to get your kids to school and back, that is technically bad debt because that car’s going to depreciate in value. However, that’s still money that was probably better spent than going out and buying an expensive new car or by leasing a car. You should pay the loan office as quickly as you can and get that behind you. But the Civic’s still going to have value well after the loan’s paid off so that loan becomes good, bad debt.
Doug Hoyes: So you’re taking two different concepts here, good debt and bad debt and kind of marrying them. So you’re taking the traditional definition. Good debt is something – if debt you incur that’s going to help you increase your wealth in the future. Buying a house being an obvious one. A mortgage is traditionally thought of as good debt because it allows me to buy a house that’s going to increase in value. What you’re saying is, “Yeah okay, but there are bad mortgages.”
Robert Brown: Sure there are. There are bad, good debt. And on a larger scale what I’m asking the reader to do is think about their debt and whether or not it makes sense in a larger context. A big mortgage on a big house has put a lot of people into bankruptcy as you know, Doug. And traditionally that would be described as good debt because chances are that house is going to appreciate in value.
Bad debt, money that’s going to depreciate in value – if it’s well thought out, if it’s well considered and if it’s paid off quickly and it’s something that you can afford in the larger context of your finances, might be the right decision at the time. I think the traditional definition is that good debt and bad debt don’t take it far enough. There’s a lot of people out there with good, and I’m using the exclamation marks to say “good”, good housing debt that can’t afford to put money away for the kids, that can’t afford to put money away for their future, they can’t afford any luxuries in life or go on vacation because they’ve got this “good” debt.
Doug Hoyes: And so it’s a question of size then, of amount. So getting a mortgage of $50,000 so I can buy a $200,000 house which is easily affordable for me, obviously that would be good, good debt – good, good debt. But buying a million dollar house with a $950,000 mortgage, which I can’t afford because I only make 50 grand a year, that’s traditionally thought of as good debt. It’s a mortgage. But that would be a bad example of it. And the difference being size then. Is that really what it comes down to, difference between size?
You’ve mentioned income as well, difference being capacity. What kind of capacity does your income have to support that level of debt, as well? So you have to look at all debt in terms of your capacity to service it. Is that ultimately what determines good debt versus bad debt? Or is it the use that you’re putting it to that has also got to be factored into it?
Robert Brown: I think another factor is or not that debt, good or bad could have been avoided or spent better otherwise in the first place. If – just because you might be financially able to be go out and buy a new car and take on some debt, that doesn’t necessarily make it good or bad. You have to ask yourself what could I have done with that money instead.
What if that money would have been better off paying down some of my mortgage? What if that money would have been better off investing into my RSP or my tax-free savings account for my long-term future? Just because you may have the income to support a certain level of debt, that alone doesn’t make it good or bad. It’s what we do with our money that counts.
Doug Hoyes: So you’re talking about opportunity costs there.
Robert Brown: I am.
Doug Hoyes: Which, I have a degree in economics so I remember that concept from many, many years ago. But that’s something you talk about in the book as well and stated very simply, you can only spend a loony once. That’s really the concept.
Robert Brown: Yes.
Doug Hoyes: I’ve got a loony, I can spend it once and do I want to spend it on payments on the house or the car, do I want to put it in my RSP? So I’ve got to ask myself a couple of different questions then when I’m trying to decide is something good debt or bad debt. Number one, what’s it being used for? Number two, do I have the capacity to pay it back? And number three, would’ve you’re money been better spent better elsewhere? And so if instead of buying that bigger house, I’d invested the money in my RSP and a TFSA and my children’s education, and something else, maybe over the long term I would’ve been better off.
Robert Brown: Exactly.
Doug Hoyes: So you’re a big advocate then for thinking.
Pat Foran: Yeah. You know when we talk about good debt versus bad debt I don’t think it’s a - it’s right to say one is – I don’t think it’s a black and white situation. But you’re right. In that book I present it in that way just to get the reader to think about their debt and whether or not it makes sense for their long term planning.
Doug Hoyes: Well that’s really the whole point of me doing the show is to get people to think. And because – if you sit there and say, “Oh, a mortgage is always good.” “Borrowing for a car is always bad,” or whatever you want to do, yeah we can always present a case that disagrees with that opinion. So –
Robert Brown: It’s interesting, I get asked a lot of personal finance questions and almost always my answer will start with, “It depends.” Every situation is different. So it’s hard to put black and white rules on everybody’s personal finances, you know, is debt bad, is debt good.
I lean toward the bad, but I also recognize there are times when debt makes sense. But as long as you’re sticking to the fundamentals of personal finance, spending less than you earn, living within your means, always saving money for your long-term future. Being comfortable with what you have rather than being possessed by what you don’t yet have. You’re going to be fine in the long-term.
Doug Hoyes: And that’s a great way to end it. Thank you very much. We’re talking about good debt versus bad debt. My guest for this segment was Robert Brown, author of “Wealthing Like Rabbits.” And you can go to the show notes at Hoyes.com to find out how to order the book or you can go to WealthingLikeRabbits.com and all the information is there.
Robert Brown: Thanks Doug, it’s been a lot of fun.
Doug Hoyes: Thanks Robert. We’ll be right back. You’re listening to Debt Free in 30.
Robin Taub: Good Debt and Investing For Your Future
Welcome back to a special good debt versus bad debt show here on Debt Free in 30. Before I give you my thoughts, let’s here from one more expert. And that’s my guest from last week’s show, Robin Taub, who made exactly the same point that Pat Foran made in the first segment. And that’s that you can’t really avoid debt. Here’s what she told me.
Robin Taub: So I think in life you can’t really avoid debt because, you know, for the big purchases, the substantial purchases in your life you’re going to need to borrow money. So I talked about earlier, getting a mortgage on a house or maybe investing in a business or buying your first car. But there’s a difference between debt that you take on to purchase an asset that has the potential to go up in value or to help you make a living, or even for example to – if you have to borrow money to go to university. You’re investing in your future earning power. So those are examples of good debt because the debt is associated with something that has – that is an asset.
Bad debt, on the other hand, is debt that you incur to purchase consumption items. So clothes, restaurant meals, entertainment, things that you know don’t appreciate but don’t go up over time. Where sometimes they actually go down the minute you walk out of the store with them. So these are just consumption items that you really should have the money already saved before you buy them. This isn’t the kind of thing that you want to put on your credit card because as I said earlier, if you can’t pay it off you’re going to be paying compound interest monthly at very high interest rates. And before you know it that consumption item has cost you so much more than the original sticker price.
Doug Hoyes: That was Robin Taub, author of “A Parent’s Guide to Raising Money Smart Kids,” giving her thoughts on good debt versus bad debt. She agrees with our other experts have said. Good debt is debt that’s associated with an asset like a house. Bad debt is money you borrow for consumption like clothes, meals or entertainment. So what have our experts told us?
30 Second Recap
Let’s review. It’s time for the 30 second recap of what we discussed today. In our first segment, Pat Foran from CTV television, says that there is good debt. He told us that a mortgage can be good debt, but borrowing to go to Cancun for a two week vacation is obviously bad debt.
In our second segment, Robert Brown, author of “Wealthing Like Rabbits,” gave us the conventional definition of good debt. Which is debt used to buy something that will appreciate in value like a house. And bad debt is used to finance something that has no lasting value or will depreciate in value like a vacation.
As we’ve just heard from Robin Taub, she agrees with those definitions. That’s the 30 second recap of what we discussed today. Before we get to my thoughts on this, I’d like to go back to a point made by Robert Brown. He made an interesting point. He said, “All good debt is not good and all bad debt is not bad.” He said that you can have bad, good debt like if you buy a big house with a mortgage larger than you can afford.
The mortgage may be an example of a good type of debt, but for you it’s bad debt because you can’t afford it. If your car breaks down and you have to buy a used car, that may appear to be bad debt because you just bought a car that will depreciate in value. However, even though it may appear to be a bad type of debt, financing an inexpensive car may be, for you, good debt. Because it’s more affordable than financing a much more expensive car.
Robert made the point that it’s not just the debt you have to consider, but also your capacity to service that debt. Your income and cash flow is more important than the amount of the debt when you’re crunching the numbers and deciding whether or not it’s good debt or bad debt for you.
So what do I think? Is there good debt and bad debt? There’s no doubt that there is bad debt. I think we can all agree on that point. If you end up with so much debt that you have to go bankrupt, that was bad debt. That’s easy. But is there good debt? I can easily make the case that no, there is no such thing as good debt.
A hundred years ago when my grandfather was 16 years old and just starting out in the world, he didn’t have debt. I’m sure he never had a credit card or a line of credit. And I suspect that when he bought his first house, many decades ago, he paid cash because that’s just the way it was. It is possible to survive and thrive without debt. You don’t have to have a credit card or bank loan or car loan or mortgage. You don’t have to pay interest and you can pay cash.
But if you make the decision to avoid debt, that also means that you probably won’t be able to buy the stuff that your friends are buying, at least not right away. I agree that it’s very difficult when you’re just starting out, to pay cash for a new car. If you want to avoid car debt you have to make the decision to buy an old clunker. That’s what I did.
My first car when I was 18 years old cost me 500 bucks and I drove it for four years until it finally died. It broke down a lot but at the time, more than 30 years ago, I had no choice. The point is debt, when it comes to buying a car, is a choice. You can take the bus or you can pay cash for an old junker or you can save for a long time to buy a new car for cash, or you can finance a new car. What’s the right choice? That’s not for me to say.
If you work the night shift there’s no bus service and you live 30 kilometers from work, you probably need a car. If borrowing is the only way to get it and the numbers make sense, then you borrow to buy a car. For you, that car loan may be good debt. If you’re a 20 year old male going to college and you want to borrow to buy a fancy car so you look cool – I get it, you’re a guy, but that sure sounds to me like bad debt.
So my answer to the good debt versus bad debt question is this, if you can avoid debt, avoid it. You pay no interest and you can never get behind on your payments. Your life may not be fancy but it will be stress free. If you must borrow for a big purchase like a car or a house, fine. I’ve done both myself. The key is to crunch the numbers first and be absolutely sure that you can make all of the payments, even if your income drops or you have some unexpected glitch in your life.
I think the reason we get into debt trouble is because we don’t think. We don’t make a plan. We don’t consider the downside to borrowing. If we did, we would avoid bad debt and perhaps even avoid a lot of the debt that we think is good debt.
That’s our show for today. Full show notes are available on our website and I’d love to hear your comments which you can leave right on our website at Hoyes.com. That’s H O Y E S . com. Thanks for listening. Until next week, I’m Doug Hoyes, that was Debt Free in 30.
Let's Get Started Segment
It’s time for the Let’s Get Started segment here on Debt Free in 30. And I’m joined today by Doctor Leanne Davies, who was my guest way back on our second show. And I’m really glad to welcome her back.
Doctor Davies has a Master’s degree from the University of Waterloo and she also has a MBA and a PHD. She has many years of experience working in the financial sector as an employee and as a consultant for insurance, wealth management, banking and financial education companies. She’s also a co-author of a book called, “When Life Bites You in the Wallet, Taking Control of Your Finances.” And chapter eight of that book is titled, “Does Good Debt Really Exist?” That’s a great question, so let’s hear the answer from the expert. Dr. Davies is there such a thing as good debt?
Lee Anne Davies: Hi Doug. No I don’t think that there is such a thing as good debt. I do think there’s such a thing as a good plan and here’s the difference. Debt is impulsive, it’s taken on so quickly because we have access to lines of credit, we have access to credit at the point of a sale, so right at the cash register. What I want to see is people who plan and they borrow for a goal.
They’re not borrowing because they just suddenly decided that they need something. And here’s where we start to get in trouble with the wealth effect. What happens is that people take on debt. They have a house that they believe is increasing in value, they’re borrowing the mortgage side of it or borrowing the line of credit against that house and their consumption goes up because their confidence has gone up.
And this isn’t even taking the wealth effect into a very specific area that I think Canadian’s are effected by, it’s the housing wealth effect. In my opinion that is our number one financial delusion. We think that we need the bigger house, we think we need the house with that granite countertop and we’re getting ourselves into trouble.
Doug Hoyes: And so the wealth effect, just explain what that means. You’re talking about the more stuff I have the better I feel? Is that what the wealth effect means?
Lee Anne Davies: That’s exactly what it is. So you’re getting some sort of adrenaline rush because you’re buying something that makes you feel great. But in the long-term it’s going to get you in trouble financially and because of the effect of that purchase it really won’t have a long-term effect in making you feel good.
And I’ll give you a really good example – we look at these houses, we buy something – I see young people saying all the time, “Well okay, I’m going to buy this house and I’m going to fix this and this and this.” Well guess what? When you upgrade your kitchen or a bathroom or whatever it is you’re doing, that depreciates very quickly. Those upgrades can come out of style within, you know, four or five years. They’re not worth as much as they were at the get go of making those changes.
We’re very delusional about this. We think that the house is going to keep increasing in value. Well it isn’t and it’s also an asset that isn't liquid. And people are forgetting that point as well. You tie up all your wealth into one aspect, you’re also going to have additional financial problems should you ever need to tap into that. And that’s why I call debt, bad. Planning is good, debt is bad.
Doug Hoyes: Well - and I’ve always taken the view that a house should not be considered to be an investment. It should be considered to be a consumable item. Just like I consume a toothbrush. I wouldn’t buy a toothbrush and expect that that’s going to maintain its value over time. A house is really the same thing. It has to be replaced over time. You have to replace the roof, you have to replace the furnace. Your example of doing the renovations which are going to have to be redone again in five or ten years as styles change.
It’s an investment only if it makes sense, if property values go up. And so the wealth effect you – I guess if I wanted to determine if I’m wealthy or not, I have to compare not only the thing I own, the house, but also the debt associated with it. And if the debt is huge, I really don’t have any wealth at all. So your concept then is don’t be focusing so much on the debt, focus on the plan to not only purchase the asset, but repay the debt. Is that ultimately how you keep yourself out of trouble?
Lee Anne Davies: That’s right. And if the plan is very diversified it makes sure that it responds to the changes in different aspects of the market place. So as equities increase possibly then your portfolio improves even as house values go down and so forth. It protects you, it has insurance involved in it, it looks at from how long you’re going to be working, if you have to take time off work for children and so forth. It gives you something solid to plan your life against and it’s flexible as your life changes.
Doug Hoyes: Yeah and I agree with you. I see that all the time. People buy a house because well the mortgage payments only going to be $1400 a month and that’s what I’m paying in rent. But they have ignored all of the other factors, property taxes, repairs and maintenance and then, you’re right, all the other expenses that perhaps go along with a growing family, day care costs and so on. You have to look at the entire picture to really have a good view of it. So the short answer to the question is, is there such a thing as good debt? Your answer is no, debt isn’t in itself good, it’s not something we should be focusing on. We should be focusing on the overall plan.
Lee Anne Davies: That’s right. It’s perfect Doug, you got it.
Doug Hoyes: Great. I appreciate you joining us, thank you very much.
Lee Anne Davies: Thank you.
Doug Hoyes: Well there you have it, a good explanation of good debt. Thanks for listening to the Let’s Get Started segment right here on Debt Free in 30.
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