Canadian ETF, Mutual Fund, TFSA and RRSP Advice  
 Efficient Market Canada
 

Pay Off Your Debts
EfficientMarket.ca

 

Pay Off Your Debts

Contributed by: martingale

Finances Most of the time, for most consumers, debt is a bad thing. If you find yourself carrying a balance from month to month, especially if it's credit card debt, you're in a financial crisis. You need to throw up a red flag, go into emergency mode, and pay that sucker off. Towards the end of this article I'll tell you how--but first, a few words about the very nature of debt. When is it a good thing? When is it bad?



Economists and financial wizards refer to debt by another name--they call it "leverage". The idea is that you can take a little of your own money, add it to a whole lot of someone else's, and fund an enterprise which you couldn't have possible paid for alone. Debt is like a great big lever which allows you to amplify the force of your own money and accomplish something truly grand. This is one of the cornerstones of a capitalist economy. This is "good debt".

Consumer debt, on the other hand, is basically evil. Generally, it means you bought something you couldn't afford, and borrowed money to get it. Worse, you paid too much for it: you're paying interest on top of the purchase price. So what's the difference? Why is debt good for capitalists and bad for you?

Here's the acid test: If you borrow money to invest in something and you expect to earn a higher return on investment than you will have to pay on the debt, then it's "good debt", otherwise it is "bad debt". When a corporation borrows money to build a telephone network it expects to generate more profits on the telephone network than it will have to pay out in interest. When you put a TV set on your credit card you've gone into debt too, but you'll never earn any profit from your TV set.

Some financial planners wrongly call mortgages and car loans "good debt", and then say that credit cards and other loans are "bad debt". That's plain wrong. Sometimes a car loan is good debt; sometimes it's bad debt. Ditto for the credit card. For example, if you ride the subway to work, and you borrow money to buy a car, that's bad debt. The car is for your pleasure only, you aren't going to earn any money from it. On the other hand, if you are a salesman, and you need that car in order to do your job, then it's an investment in your sales business--good debt. For example, if you purchase a TV on your credit card so that you can kick back and watch the hockey game, that's bad debt. But if you travel to another city in order to make an important business deal, and you put the hotel room on your credit card, that's a business expense--good debt.

No matter what kind of debt you have you should seek to pay the least interest you can. Credit cards have horrible interest rates--typically 17-18%, often over 20%. Even the cheap ones offer rates of no less than 10%. You can almost certainly get a lower interest rate from your bank on a loan or a line of credit. Depending on your credit rating, you should be able to get a loan for one or two percent above prime. With prime currently at 4.5% that'd be 5.5 or 6.5% interest--half or a third what the credit card was charging you.

If you have any credit card debt that you carry month to month pay it off. If you can't pay it off, go to your bank and get a loan in order to pay off your credit card. Never pay an interest rate more than one or two percent above prime. Absolutely never.

If you are considering investing in the stock market and you have outstanding debt, what are you thinking? If your interest rate is 7% then a payment on that debt is a guaranteed return of 7% for you--your investment in debt repayment will compound at your interest rate. That's an unbeatable investment! You could never do better than that in the stock market or anywhere else. (You could earn a higher return on the market, but only in exchange for taking on a higher risk--in terms of the risk/return ratio, the debt repayment is much, much better.)

Another wrong thing people say is that "good debt" is used to purchase something that appreciates, and "bad debt" is used to pay for something that depreciates. This would always call a car loan "bad debt", as the car depreciates in value, but as we've seen a car loan can be good debt if you are in the business of driving around. Meanwhile if you purchase something that appreciates at a rate of 2% a year, and you are paying 6% interest on the debt, it's just a loss. The acid test is always whether or not you anticipate a return on investment that is higher than your interest rate.

Mortgage debt is trickier. Some financial planners always say that a mortgage is good debt, but again that is wrong. Sometimes mortgage debt is bad debt. I will cover the issue of mortgages more fully in the real estate section of this site, but the short answer is that you need to calculate how much you would have paid in rent, versus how much you are going to pay in mortgage interest. Then pick the cheaper alternative. There are many, many other issues in the decision to buy a home, though, and I will have to cover them in a separate article.



Story Options

What's Related

Pay Off Your Debts | 5 comments | Create New Account
The following comments are owned by whomever posted them. This site is not responsible for what they say.
Pay Off Your Debts
Authored by: FrankW on Monday, December 20 2004 @ 08:36 PM EST
Admin,

I find the concept of "good debt" and "bad debt" a bit extreme. Instead I think
people should think in terms of "efficient debt", and that they approach debt
with an eye towards why they are going into debt.

So as you point out consumer debt (especially credit cards) is usually must less
efficient debt than a bank loan. This is fair, and clearly it is very inefficient to carry
any amount of credit card debt for an extended period of time. Anyone with a
respectible credit history can normally get an unsecured line of credit with a bank
at a much better interest rate.

Even better if you have a decent amount of equity in your home is to get a secured
line of credit (against the equity in your house). This can cost a bit of money (a
few hundred dollars for the property review, and registering a lien) but can give
you a very cost-efficient means of borrowing when needed.

You seem to suggest that borrowing for "consumption" is wrong. In general I
would agree with this, though there can be exceptions. I would encourage
people to consider whether they can practically afford something they want to
buy now, but have to borrow for. It might make sense if you are borrowing now
because you are confident you will have a windfall of income, or a substantial raise
in the future. Or if you are borrowing to purchasing something that will save you
money over it's life. But borrowing just to have "nice stuff" now with no clear
plan on how it will be all paid back seems dangerous to me.

In my own case, my wife recently decided to go back to school for 4 years. We
were faced with supporting our family with just my income where we had been
doing so with two incomes. Given the substantial reduction in income, we took
some steps to reduce expenses. But also, because I could forsee a resumption of
incoming in 4 years, we got a line of credit against our home so that when we
needed it we could borrow efficiently with a reasonable expectation of paying it
off once my wife was back working.

Keep up the good work on the site!


© 2004-2016 Efficient Market Canada Canadian ETF, Mutual Fund, TFSA and RRSP Advice Self-Directed RRSP Advice