How to tell the difference between good and bad debt

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Given that interest rates are still in flux, fixed mortgage rates are higher, the continued use of home equity lines of credit (HELOCs) and more regulatory measures to keep Canadians mindful of their debt loads, is it worth going into debt to achieve your goals?

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Debt can be good or bad, but it’s not always a clear-cut line. The key distinction between good and bad debt is in the outcome, so before you take on any debt, decide if you will be better or worse off once all the payments, interest and fees have been accounted for.

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For example, credit cards, in-store financing plans, consolidation loans and payday loans are all considered bad debt. The interest rates are typically on the higher side and these forms of credit tend to pay for day-to-day expenses. Without a budget to account for how much you can afford to spend on things ranging from vacations, dinners and drinks, to clothes, household décor, furniture and appliances, to even groceries, gas and daycare, using credit to cover the shortfall does little to move you closer to your financial goals.

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Good debt, on the other hand, includes a reasonable amount of student loans, an affordable mortgage and the careful use of a HELOC. These forms of credit help you work towards long-term financial stability. Borrowing to further your education is an investment in yourself. Saving up a down payment to buy your own home helps provide your family with a stable living situation. Using a HELOC to do renovations can increase the value of a real estate asset or allow you to generate income from it — for example, a mortgage-helper suite. These are all ways that credit can be beneficial to achieving your goals.

However, too much of a good thing has a way of turning out badly. For example, financing a new car rather than buying a more modestly priced used car. The perpetual student who maxed out their student loans, but still needs to complete their education to obtain a job that pays enough. Those who maxed out their mortgage when rates were low and life was good, but didn’t save for a rainy day and higher interest rates. And there are countless Canadians who use their low-interest HELOC to pay off their high-interest credit cards. The form of credit might not be bad, but the situation could be.

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With that in mind, here are nine tips to live a rich life without succumbing to a bad debt situation.

Create a realistic spending plan that doesn’t rely on using credit cards to get by. That will reduce the need to use your HELOC to pay for lifestyle expenses.

Pick what you splurge on: clothes, sports, travel or electronics, but not all four. Adopt a minimal mindset for the rest.

Learn how to benefit from being frugal versus cheap. Being cheap means buying the lowest-cost items, which can end up costing more in the long run. Frugality is all about prioritizing your spending choices and making economical decisions so that you can have more of what’s most important to you.

Surround yourself with like-minded people. If your whole circle of friends spends with social media in mind, it will be hard to step back and resist that pressure.

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Gently used cars come with lower price tags. The worst years of depreciation were absorbed by the previous owner and many used cars are still under manufacturer warranty. Learn how to car shop like a pro and drive away with a deal that fits your budget.

Look for alternative ways to fund post-secondary education for yourself or your children. Use student loans sparingly.

Buy less house than you’ve been pre-approved for. If you already own and downsizing isn’t a good option right now, find ways to generate income with your home.

Pay down your most expensive debts. Choose the snowball or avalanche method and tackle them systematically.

Continue to save towards your short- and medium-term goals as well as retirement. Let the magic of compound interest work to your advantage. Plan your timeline to avoid retiring with debt.

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Some of these tips will be easier to implement than others. Keep in mind that one of the best ways to help everyone in your household stick to your overall financial plan is to give each person some mad money. Allocate a small amount of cash for each person to spend or save any way they like. It helps young children learn about money and older kids to learn how to budget for what they want. Enjoy spending the mad money guilt-free because it’s not taking away from any other goals.

Before using any form of credit, apply the litmus test for good versus bad debt. Decide if going into debt with a particular spending choice finances your current lifestyle or helps you move forward with your goals. Then make your borrowing choice accordingly.

Sandra Fry is a Winnipeg-based credit counsellor at Credit Counselling Society, a non-profit organization that has helped Canadians manage debt for more than 26 years.

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