Credit. Debt. To many people, these are scary words. And why shouldn’t it be? In news, and media, we often hear stories about someone “going into debt” or companies becoming “bankrupt” or homes going into “foreclosure”. Some of us may even have heard stories about people turning to suicide due to the financial crisis of 2007. For some of the not so young people, they may have even heard stories of the financial crisis of the 1930’s great depression. All of these horror stories make people very reluctant to borrow. Today, as a continuation from an article 2 weeks ago on credit, we’ll be discussing a closely related concept: debt. Hopefully, after this article we will all become a bit more knowledgeable, and perhaps a little less fearful.
What is debt? In simple terms, debt is money owed to someone. Whether it’s to the bank, to a car company, to a friend, or to your mom, it’s all referred to as debt. When debt is explained like this, it’s probably quite difficult for people to imagine someone who doesn’t have any form of debt, at any single point in their lives. For example, those of us who have credit cards add on debt every time we use it.When you finance a car, you have debt to the car company, or the bank. Even when we are children, if you borrow five dollars from your friend, you have a bit of debt.
Is debt bad? Well, yes and no. The question really depends on the kind of debt you have. You borrowed money, but what are you intending to do with it? One of the first forms of debt that we take on is something called a “student loan”. Is it bad to take on a student loan? Some people would say yes, some would say no, but what are they basing these arguments on?
In the same vein, I’ve talked to someone a generation older who said that “if you can’t buy something in cash, you shouldn’t buy it”. He is the type of person who believes that debt is the devil. I pointed out how that was very easy for him to say, when considering he bought his family home more than 25 years ago in North Vancouver, when real estate prices were literally about 6 times less than what they are now. It’s a little bit facetious when $150,000 would have bought a home back then, whereas to buy a similar home it would now cost over a million. Is it bad to take on a mortgage? If so, why do literally millions of people in Canada have mortgages?
How do we determine if debt is good or bad? This is the important part. To determine good debt or bad debt, we need to look at a number of factors, although the biggest 2 are the following:
1. What is the money being used for?If you took out a $20,000 loan from the bank in order to buy a boat, we could quite easily assume that this is probably a bad debt, unless it’s a fishing boat and you’ve decided to make a living as a fisherman. This is because a boat is purely a luxury item for the vast majority of people. It costs money not only to buy the boat, but also to moor the boat, and to maintain the boat. If you took out a loan in order to go to school, this could be a type of “good debt” because supposedly, a degree could help you with your career or earnings later on in your life. Taking on debt in order to buy a home could also be considered good debt because you can live in a home,it can increase in value, and it could also generate income if you have renters.
2. What are the terms of repayment?This is very important, because the terms of repayment could change something that’s a good debt into bad debt very easily. The terms of repayment on any amount you borrow breaks down further into several factors, although the two I want to talk about are interest rate, and time.The interest rate tells you how much extra you are paying in order to have this loan. For example, if you take on a loan of 1 million with a 4% interest rate, this means you would pay$40,000 of just interest in the first year. Obviously, we would want this rate as low as possible.
The other factor is the time for repayment. Going back to our example, if the mortgage is to be paid off over 5 years, you would pay $40,000 of interest in the first year, a little less the second,a little less the third, until you finish of paying the interest and principle. If you take longer to pay off the principle, the total interest you pay would be higher. The benefit of this, however, is that your payment amount per month, could be lower.
What we touched on today are just some very basic principles around debt. To understand more, you would have to do a lot more research, or better yet, consult an advisor. Talk to us and we can help inform and educate you about the things to look out for when it comes to debt, and hopefully help you make the best decision for you and your financial situation, whatever that may be.
The bottom-line. If you need to borrow money to buy a boat, you shouldn’t buy a boat.