Canadian Entrepreneur with Global Invest, on a mission to help people invest in real estate to create generational wealth.
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Is it a good idea to take out consumer credit? This is a question many investors ask themselves at one point or another. Indeed, getting into debt takes money from one’s future assets to use in the present — while paying interest for this service. For real estate investors and those curious about real estate investing, distinguishing between types of debt can help support your journey.
Debt can be a good decision, but most of the time it is not. How do you know? Well, let’s sort out good and bad debt!
How do you distinguish between good and bad debt?
The debt generated by a consumer credit is generally considered good in certain situations. For example, if you find yourself in a better personal and financial situation after paying off the debt or if it guarantees that the debt will be completely refunded before the due date(s) arrive.
Thus, if you look at it from a financial point of view only, the ideal debt will finance a good or service that will enable you to:
• Refund the amount borrowed (the asset acquired must therefore retain value).
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• Payback the interest on the debt (it must also generate income).
• Generate an income that will enable you to become wealthier (otherwise the operation would be neutral).
Examples Of Good Debt
Good debt is defined based on what it enables you to purchase. For the Financial Consumer Agency of Canada, it is a loan that is invested in a profitable business or in a business with value increases over the years. Here are some examples of the types of credit that can be described as good debt:
A Mortgage To Buy Your Main Residence
Buying a property as well as your main residence is often a good idea if you intend to stay in the same place for a considerable length of time. Though the property does not generate income, it allows one to save money on rent and use that “savings” to pay the mortgage while the property appreciates.
Consumer Credit For Students
In general, obtaining a degree is equivalent to acquiring knowledge and skills. The higher the level of education, the higher the income you can expect. Getting a loan to finance your studies can be considered good debt.
Consumer Loan For Business And Investment
If you need money to grow your business, then a consumer loan taken out for this purpose can help generate a return. If this return is higher than the interest rates on the loan, then it can be a good debt.
Obtaining Credit To Invest In Real Estate
Real estate, on average, tends to increase in value over the long term. Whether the property is owned directly or via an SCPI, a private investment company, it can be a win-win situation if the net rents offset the loan rate. The leverage effect, which consists of developing your assets thanks to borrowed money without a personal contribution, then comes into full play and allows the capital to grow.
It is a matter of budgetary balance: you must calibrate the financing so that refunding the loan remains bearable and doesn’t overstress you. You must never sacrifice your leeway. In this case, consumer credit can be considered good debt.
Bad Debt
Bad debt is much simpler.
Bad debt finances expenses that won’t generate substantial returns nor increase in value. When consumer credit finances the following purchases, it is certainly bad debt:
• Capital goods (furniture, Hi-Fi, kitchen, etc.);
• Clothing;
• Nonessential renovation work;
• Consumables (goods that disappear as soon as they are used: holidays, hairdressing, weddings, entertainment, etc.);
• Fast-moving consumer goods (groceries);
• Material urgency (whereas you should use your precautionary savings).
The common characteristic of all these purchases is that they do not generate cash flow or expense savings.
You have seen that a good debt pays for itself (or at least contributes to the principle) through the extra income it generates.
A bad debt, on the other hand, does not contribute to its repayment. It leaves you with the entire burden! This is the main difference from good debt.
Having a bad debt means sacrificing the future for the present, and using the fruits of your future work not to consume or save, but to pay back past expenses (with interest).
Consumer credit can also be a bad debt.
This debt can make the lender poorer. The same goes for payments in 10 installments with no charge: it’s free, but it’s still a credit!
A debt remains a debt.
Beware: the bank cards used by major financial institutions (PASS card, etc.) may seem like payment solutions, but their “additional services” encourage deferred debiting and consumer credit. These cards can be a gateway to financial ruin if you are not careful.
Finally, distinguishing between good and bad debt will also depend on your life and your personal goals: The financial aspect is not everything.
Even if a debt is good “on paper,” you are under no obligation to take it out. Not owing anything to anyone is a great freedom.
On the other hand, debt should never be a response to an unbalanced budget, as it does not solve the imbalance. Don’t be a perpetual debtor, chasing credit offers touted by banks and credit agencies. Don’t live on credit, work on your budget first and foremost, possibly with a financial coach.
How can you avoid getting into bad debt?
The solutions I generally suggest to potential borrowers are simple. To ensure that your consumer credit does not turn into a fiasco, do a simulation. Then, you will be more aware of your expenses and you will have a clear idea of your borrowing capacity.
However, if you are already trapped in a vicious circle of bad debts, do not panic. Take the time to assess your ability to repay the loan. Once you have done this, draw up a repayment plan, prioritizing debts with the highest interest rates. There are also a number of methods shared by those with personal and professional experience in financial planning.
Now you are equipped with the necessary information to distinguish between a good and a bad debt. Your future investments are already better for taking in this knowledge.
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