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Good Debt vs. Bad Debt: Unraveling the Financial Web

Articles, Financial Wellness

Financial Wellbeing

When we think about debt, our minds tend to go negative. We think about student loans, credit card bills, and car payments. But not all debt is created equal, and in the realm of personal finance, there exists a necessary distinction between good and bad debt.

 

Understanding this difference is crucial as you navigate financial planning. Whether you’re a student just embarking on living independently, a new graduate paying down a loan while moving into your professional career, or a homeowner balancing expenses – diving into the difference between debts is a great way to better understand how to build your credit and better manage finances.

 

Let’s start by drawing on the most common sources of debt, like student loans and mortgages, and look at how debt choices can profoundly affect your credit score.

Where Most People Find Themselves in Debt

When we shift our focus to personal finance, we find that debt is a common part of life for many Canadians. According to a report by Statistics Canada, the majority of Canadians carry some form of debt, with the average Canadian household debt, not including a mortgage, amounting to almost $41,500. 1

 

In terms of personal debt, the average credit card balance for Canadians in the first quarter of 2023 was $3,909, according to Transunion. This is an increase from the average monthly credit card spend of almost $2,447 in the third quarter of 2022, which is above the 17.3% from the same time in 2021, and up 21.8% in 2019, according to Equifax. 2

 

Another big driver of debt is student loans, with the total student debt in Canada amounting to at least $18 billion. There are more than 1.7 million student borrowers in Canada, and the average student owes at least $26,075, with an average interest rate for government loans remaining around 2.5%. 3

Here’s a breakdown of the most prevalent sources of personal debt:

Owning a home often requires taking on a mortgage, which is generally considered a form of good debt due to the potential for property appreciation and ownership.

Credit card debt is a prime example of bad debt, given its high interest rates and potential to spiral out of control.

While car loans can be either good or bad debt depending on the terms and your financial situation, they are often seen as necessary for transportation.

Student loans are a significant burden for many young Canadians, and their classification as good or bad debt depends on how they are managed. Paying a student loan down at a longer term may amount in more interest, prolonging the time it takes to get the loan fully paid off and increasing the amount owed.

Good Debt vs. Bad Debt: Impact on Your Credit Score

Understanding the distinction between good and bad debt is pivotal to managing your finances and credit effectively.

Good Debt

One of the key components of good debt, which implies that your debt is being managed responsible, is that it can improve your credit score. Good debt can include mortgages or installment loans, which can positively impact your credit score by demonstrating your ability to handle financial obligations. Good debt often involves investments in appreciating assets, such as a home or education, which can contribute to your long-term financial well-being and your ability to build a strong set of assets.

Bad Debt

Bad debt, on the other hand will often negatively impact your credit score. Bad debt can include accumulating high-interest debt, like credit card balances, which hurt your credit score and signals potential financial instability. Because the interest rates on credit cards are high, bad debt tends to accompany any type of high interest rate purchase, as paying off debt over time becomes even more costly.

When you’re thinking about how to define whether the investment or purchase you’re making is beneficial to your longer term financial goals, the distinction between good and bad debt is not only significant but also profoundly influential on your financial health and credit score. When navigating the complex world of personal finance, consider speaking with a personal financial planner to better understand and work toward your long-term goals and while understanding the consequences of your debt choices. Aim to prioritize good debt that aligns with these goals while actively managing and reducing bad debt or any outstanding loans you may currently be paying down. By making informed decisions, you can set yourself on a path to financial stability and success.