Debt

The Bad and the Ugly 

In the last blog, I reviewed what I see as ‘Good’ Debt.  Today’s discussion will focus on Bad Debt, Ugly Debt, and some financial strategies I would apply if I had a ‘do-over’, restarting as a 25-year-old. 

The Bad 

A bad (or not as good) debt is a purchase you NEED to make, but you don’t have the money to pay for all of it now.  For example, you need a reliable car to get you to work, you need to move for a job.  Even though you are purchasing for a ‘need’, not a want, you still need to be able, comfortable, and diligent in paying this debt off; the sooner you do so the better because this debt is draining away your income.  Before assuming the debt, ask yourself, can I function without this purchase (answer should be no), and can I pay it back (answer should be yes).   If you can live without it, or you will have difficulty paying it back, this becomes an ugly debt. 

The Ugly 

What is ugly debt?  One of the worst advertisements I remember seeing was for a credit card company.  The message was people ‘deserved’ a vacation and therefore should take one even if they hadn’t saved for one and couldn’t afford it.  And the ad then had people putting the vacation on the credit card as the ‘solution’.  This is good marketing, but a terrible, ugly idea. 

If it is something you don’t need, something you can’t afford (you can’t pay for it today), going into debt to get it is ugly debt.  What makes this debt even uglier is much of the time it is carried on credit cards, which charge 20%+ interest.  This is like dealing with a legal loan shark.  Avoid any ‘buy now, pay later’ incentives, unless you can pay now. 

A quick google look shows credit card ‘balance’ in Canada at $4500 per consumer.  The US is $7000 per borrower.   Assuming this is the balance after the monthly payment has been made, it is ugly debt.  If your credit card balance is paid in full every month, you are not really carrying any debt, and may get cash back, so this can be good, but only if you always make full payments each month.  How much credit card debt does the average Canadian have? - MoneySense 

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A Few Good Strategies  

If I had a do-over today, what would I do financially?   I have applied some of the following, but not all.  I believe if one applies as many of these as possible and does them as early in their financial life as possible, they will be soon secure in their finances. 

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1.       Make up a budget.  Know what your earnings are each month and know where you are spending this money.  If you can’t plan it and measure it, you can’t control it. 

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2.      Pay yourself first, savings should not be an afterthought.    In your budget you should know how much you spend on the big items (lodging, food, transportation, etc...)  You should also ‘know’ how much you need to save this month.  Make these savings a priority.  Pay yourself each month, and if the money goes automatically into a separate account, it is even better.

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3.      Have 3 months of ‘survival’ money saved and accessible (in easily cashable investments).  If your monthly cost for minimal survival (shelter, food, payments and work) is $3000 per month, save as much as you can monthly to build up $9000.  I know it is tough, especially when you are starting out, we didn’t get this in place until quite a few years after we were married.  This amount will help you to navigate many of life’s issues without requiring debt.  The loss of a job, a car breakdown, a health scare....  many of life’s challenges and costs will fall into ‘3 months of living’ threshold, and if you can afford them without debt, you will be far ahead financially. 

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4.      Invest.  The best way you can get to a place where your ‘money is working for you’ is if you save and invest.  One can spend the money they make and ‘live for each moment’.   I understand the alure of this approach, however, this enslaves one to a frugal retirement.   I believe a better approach is to live so you can save and invest and thereby be able to retire knowing you can then do a whole lot of ‘living for the moment’.  

With these strategies, you are/will be well on your way to avoiding the ugly and bad debt, and could be quickly pivoting to thinking, where is the best place for me to invest come money.

Debt

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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.

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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.

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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. 

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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. 

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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.  

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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. 

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Here is a link to a great site for calculating anything mortgage related: Mortgage Calculators

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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.   

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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.