I’ll never forget those sleepless nights a little over 10 years ago, when we were in the process of buying our first house.
I’d wake up in a cold sweat, with a mantra running through my head: “one-third of a million dollars, one-third of a million dollars…”. That was the price we were going to pay for our house, and most of it was going to be debt, in the form of a mortgage. (Other nights I’d wake up after reading imaginary headlines about a “Toronto Housing Market Crash” in a recurring nightmare.)
Today, of course, the market still hasn’t crashed and that house is worth a lot more than the three hundred thousand and change we’d paid for it. We’ve since moved twice, taking advantage of the equity we’d built up – and rising property values – to get to the bigger house in a nicer area where we live now. Lost sleep aside, taking on that debt has proven to be a good financial move.
Did you know that there are two kinds of debt: good and bad?
The good kind, also known as “constructive” debt, is the type you take on with a long-term goal in mind. The most common example is a mortgage, but things like RRSP's or student loans would also count. The payback with student loans is pretty obvious. High school students choose to go to college or university based on the idea that they’ll likely graduate into a higher paying career than they would with just a diploma.
Adults too can choose to go back to school to enhance their skills, or transition to a different career track. Either way, Stats Canada figures show that university grads earn about $23,000 more than those with only a high school diploma. In both cases, the formula falls apart if you don’t land a better paying job and/or don’t pay off the loan as soon as possible after graduation and the debt turns into a deconstructive burden.
RRSP loans are a little trickier. The banks love giving them – so much so that they’ll typically offer you a no-interest grace period to pay them off after you get your tax return – because it means they’re also getting your RRSP business. But you need to crunch the numbers (or have an accountant or financial planner do it for you) to determine if it’s worth taking on debt for a tax deduction.
To give one example, let’s take someone working full-time earning about $75,000 a year. If they were to put $12,000 into their RRSPs (or $1,000 a month), they would likely get back about $4,000 in a tax return. If you don’t have twelve grand on hand, it may not be worth taking on that much debt, even with a grace period, if it will just turn into a mound of deconstructive debt.
On the other hand, if you were planning on buying your first home in the near future, it might be a good move to aggressively buy RRSPs, then withdraw them through the federal Home Buyers’ Plan at up to $25,000 a person (or $50,000 for a couple) to use as a down payment on a house.
The most obvious example of deconstructive debt is carrying a balance on your credit card.
Rather than an investment, the danger with easy credit is that too many people use it to spend frivolously on consumer items they don’t really need, accumulating monthly bills they can’t pay off. Plain and simple, the only way to avoid building insurmountable debt is to avoid this kind of spending - but choosing a low interest credit card with a low balance transfer rate can help minimize the damage. One such card - the MBNA TrueLine MasterCard offers a 12.99 per cent interest rate and balance transfer rate and no annual fee.
When good debt goes bad
Yet even the most popular form of constructive debt – a mortgage – can quickly turn destructive if circumstances change.
Illness, getting downsized out of a job, or any number of factors can impact your ability to keep up with your payments. Disability insurance can buffer the impacts of unforeseen illness. Otherwise, the best hedge on your mortgage gambling bet is to make sure you can realistically afford the amount you’re considering signing up for.
Banks, financial planners, and the Canada Mortgage and Housing Corporation all have online tools and calculators to help you figure out the amount of debt that you should be able to manage based on your income.
Yes, taking on a lot of debt can be stressful. But think for a second about the Warren Buffets and the other uber-wealthy leaders of the financial world. Unless they inherited their money – or are paid actor’s/athlete’s salaries – odds are they’ve accumulated their houses, cars, and private planes by taking on calculated amounts of constructive debt.