Debt
The Good
A couple of weeks ago, Grant and I were talking about government and personal debt. Grant (maybe foolishly) asked if I would put together a ‘Be Prepared’ segment on debt. I (maybe also foolishly) said yes.
I would like to focus on personal debt as I believe this has affected all of us in the past, maybe affecting us today, and could be something that we can positively affect in the future. Also, I believe that since my wife Pat and I have already lived through many of these scenarios, this blog is more aimed at the next generation. Finally, this blog does not mean I have always practiced what I preach.... Pat has been a great partner through the financial challenges we have faced; I have made plenty of mistakes, some I have learned from, some I am learning from, and some I may never get a handle on.
I have always looked at debt as ‘good’ versus ‘bad’. I’ll add an ‘ugly’ debt scenario, mostly because I believe there are pitfalls we (and our kids), can avoid in the future. And my caveat is.... I am not an economist, and the history and results that I have seen do not guarantee the same results in the future, but I do hope they are similar.
The Good
Good debt... it almost sounds like an oxymoron. I see ‘good debt’ as debt is working for you, not against you. If the eventual value of an asset is more than the total cost (debt and interest) paid to own the asset, this is good debt. A great example is a mortgage to purchase a home. Imagine purchasing a home for $500K today. You have $50K down payment and require a $450K mortgage. Your mortgage rate is 5%. Let’s assume it stays at 5% for the entire 25-year amortization (total time to pay the mortgage back). The total cost you will pay is:
$50K down payment
$450K mortgage loan you need to pay back
$335K interest
$835K is the total you will pay for the home.
The value of the property in 25 years will almost certainly be worth more than the $835K you will have paid, so this is a good debt. In the last 100 years, most homes in Canada have tripled in value over a 25-year period. If the home you purchased even just doubles in value in 25 years, you would be ahead. The above gain is not guaranteed and may not apply for every type of home in every location in Canada, but it is usually true. As an example, the Average House Price in Canada peaked at over $800K in 2022, and now sits at $673K, a fall of 15%, which sounds bad. The average house price in 2001 was $191,000, so even at today’s average, home prices have gone up 3.5X.
Like all purchases or investments, there are potential downsides to home purchase.
· You are tied to this asset. It may be difficult/expensive to sell the house, so don’t think of it as a quick and easy investment to get in and get out.
· Purchasing your first home has many first time and extra fees (legal, real estate, taxes, insurance, furniture, tools, gardening equipment, etc...). This is not as simple as ‘rent is expensive so I might as well buy’. Get a good grasp of all the costs before you buy.
· You will need money for repairs, maintenance, and renovations, which hopefully come a little later in the life of your home, when you can afford these.
· There is a valid argument that renting and investing the extra money it takes to own a home is a better approach. This is probably true, but requires a lot of discipline, since the temptation to spend this extra money instead of investing it is hard to resist.
· The value of your home will fluctuate. I.E. 2007, 2019, and 2022 till today all saw downward slides in the price on homes in Canada, so it is important to make a home purchase with a long-term view, not a 3-year view.
· The banks in Canada do a very good job of ‘stress testing’ your ability to pay the mortgage debt, but you should still make sure you can afford to purchase a home today and know you can still afford it if the interest rates go up a couple of percent.
Here is a link to a great site for calculating anything mortgage related: Mortgage Calculators
Other ‘good debt’ examples could be to open a business, to purchase rental properties or land, to pay for an education, to invest. Doing an initial comparison of what you will pay including the debt, interest, and even income taxes (if borrowing to invest), compared to what you will gain, will help you determine if this is good debt.
In the next blog, I will describe what I see as Bad, and even Ugly debt, plus will review strategies I would definitely use if I was a 25-year-old and had the opportunity to relive my financial life.