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Is debt necessarily bad? Not necessarily.
I’ve talked about Dave Ramsay on this blog before. While he’s been influential in helping me to learn to live within my means and set myself up for financial security, one of the things I don’t agree about his philosophy is his agenda against debt. Ramsay believes that all debt is bad, any talk of leverage is only in the aim of tricking the unsuspecting everyday consumer, and we would do well to get rid of our credit cards and pay for everything in cash.
Dave’s reasoning comes from years of experience helping bail people out of debt they should not have taken on. While I agree that having access to a large amount of credit could be dangerous for people who lack complete self-control, I do think the majority of people could benefit from taking advantage of certain kinds of debt. In other words, if you’re the type of person who makes financial decisions purely on emotion, it’s probably better not to take on any debt. However, if you believe you can make decisions based on the numbers, debt can be really beneficial for you.
Good vs bad debt
The main rule of thumb is: any debt that will allow you to accumulate wealth at a higher rate than you are paying in interest is good debt. The market rate of return for equities is around 6%, so generally any debt which allows for an interest rate of less than 6% would be considered “good debt”, unless you are using the proceeds from the loan to purchase an asset which will generate a return of less than 6%. I’ve provided a few examples below.
Good debt – house
There’s a reason why people put a down payment on a house as soon as they can. A house is one of the few assets that is almost guaranteed to appreciate in value – a house in Toronto generally appreciates 6% per year. In addition, if you can put 15% down, the typical interest rate is 1.37%, which is far less than the rate at which your house will appreciate. This means you’re using debt to start getting home equity appreciation early, which will amass your more wealth in the long run.
While the above reasoning would apply to both investment properties and personal homes, for a property you want to live in you can also look at the situation from the perspective of opportunity cost. You are going to want to buy a house eventually, it’s just a matter of whether you pay for it via mortgage or with cash. If you were to save up all your money over the years, keep it as cash and only pay for your house via cash will cost you all the returns this cash could have earned in the stock marker in the meantime – I.e. 6% annually. Therefore, it is far more beneficial to pay a down payment as soon as you can rather than saving up and buying your house in cash.
Good debt – education
This one is tricky, as there are a lot of different degrees which cost different amounts of money and also equate to different types of earning potential. You’d have to crunch the numbers for each individual degree to see whether you end up with a positive return. I took accounting in undergrad, so I’ve created the example below for accounting students:
The average business degree tuition in Ontario is $6,800 for 4 years, equating to $27,000 overall. Let’s assume you didn’t receive any scholarships or OSAP grants but took the full amount as a loan. OSAP loans are interest-free while you are in school. Ideally, you could work part-time to gather money to pay off your loan as soon as you graduate, but let’s say you need that part-time income to cover your living expenses.
Your earnings after you graduate are expected to be $45,000 per year. That means you can pay off your loan in less than two years (assuming 50% of your income went to paying loans). Accountants with university degrees earn annually 25% more than bookkeepers, which is much higher than the interest on your loan.
Good debt – investment in small business
To get a small business off the ground often requires some capital investment. You might consider going to the bank to get a loan. Small business interest rates are typically around 3%, while small businesses average a growth rate of 8%. Of course, small businesses also tend to be risky, and banks often take this risk into account when giving you loans, so make sure you expect to grow at a higher rate than the loan they are giving you.
Bad debt – car
Here’s where I completely agree with Dave Ramsay – his rant on the trap of car loans is completely accurate. A car is not an investment, as it depreciates in value for every mile you drive. Therefore, you should be buying a car in cash rather than taking out a loan on it.
Bad debt – credit cards
Ah, the evil that is often touted by those in financial ruin, and with good reason. Credit cards have insanely high interest rates of around 17.28%, which is much higher than any return you could get on any investment. But that doesn’t mean you shouldn’t use credit cards; in fact, using credit cards can provide lots of benefits, like helping to establish your credit history so you can get some of the lower-interest loans mentioned above, or getting cash-back an other benefits that credit card companies offer. Just make sure to pay off your credit card balance at the end of every month so you don’t incur any of that nasty interest! Hopefully reading this has helped you to realize that debt is not the devil; you just need to make sure you can get it to work for you rather than against you. Happy borrowing!
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