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It's one of the most powerful mood-elevating substances known to humankind. Users say it imparts a sense of euphoria, even invincibility, that can last days, weeks or years. As with all uppers, it's highly addictive. Yet despite years of warnings, this colorless, odorless substance is now found in nearly every household in Canada.
We're talking about debt, of course. Over the past 25 years, Canadians have become hooked on loans. From 1976 to 2002, household debt per adult surged 629%. In 2003, for the first time, the average Canadian owed more than his or her annual disposable income. With mortgage debt and student loans on the rise, our borrowing binge shows no signs of winding down.
Is this trend dangerous? If this were the typical article on debt, we would be the first to nod our heads yes. But you, dear reader, know as well as we do that debt should be approached with caution, so we won't waste our breath or your time belaboring the point right now. We all realize that easy credit can lure people to pile up obligations they can't pay.
The problem is that most of us can't avoid some form of borrowing. Unless you're born with rich and generous parents, it's almost impossible to negotiate life without taking out at least a few loans. If you want to attend university, buy a car, purchase a house, or open a business, you're going to go into debt. The challenge is finding ways to make debt work for you instead of against you. And that is easier than you may think.
Rather than deploring all debt as mortal sin, you should think of borrowing as a question of good debt vs. bad debt. What's bad debt? Indulging in a Caribbean vacation you can't really afford and charging it to your credit card. Or signing up for a high-interest personal loan so you can buy a Corvette or a new wardrobe. While the specifics will vary, you can identify bad debt by three tell-tale features:
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It's expensive. Credit cards typically gouge you for 18% or more in annual interest charges while high-interest personal loans smack you with a punishing 10% rate or more. |
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It's not tax deductible. You can write off interest on loans only if you borrowed the money for investment purposes. That's obviously not the case when it comes to loans for vacations, sports cars, clothes. |
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The debt was incurred to buy a depreciating asset — in other words, an asset that begins losing value the second you take possession of it. Some common depreciating assets are electronics, vacations, cars, clothes and restaurant meals. In all these cases, the value of your purchase starts falling as the size of your debt starts rising — not exactly a good formula for building up your wealth. |
In contrast to bad debt, good debt can help you become richer. How do you recognize good debt? It's cheap. It's incurred to buy an asset that has a reasonable chance of going up in value. And it may even be tax deductible. Classic examples of good debt are borrowing at an attractive rate of interest to invest in stocks, a business or a rental property.
Good debt comes in other forms as well. A student loan that allows you to attend school and acquire skills that will boost your earning power is nearly always good debt. Also worthwhile is a mortgage that lets you buy a reasonably priced home for yourself and your family.
The best way to think of good debt is as a magnifying glass. It makes the payoff from a good investment even bigger. If you're a homeowner, you may already know about this magnification effect. Say you put $20,000 down on a $200,000 house and take out a $180,000 mortgage to pay for the remainder. If your house then rises in value to $220,000, its price has climbed 10% — pretty ho-hum. But look at what's happened to the value of your stake. Instead of rising only 10%, your equity in the house is now worth $40,000 — the new $220,000 price minus your $180,000 mortgage. That's a 100% increase on your original$20,000 investment. And it's all because of the magnifying effects of debt.
If this were the only way debt worked, it would be truly wonderful. Problem is, the magnifying effects are equally awesome in reverse. Say, for instance, the home in the example above falls in value by a mere 10% just after you buy it. Your entire equity is wiped out. If you were to sell the house, you would be left with nothing.
Note that in either of these examples, debt doesn't determine whether you make a profit or suffer a loss. All it does is decide how big that profit or loss will be. It pays to keep that point in mind. If you're thinking of borrowing to make an investment, put first things first. Before deciding how much to borrow or how to structure the loan, consider whether the underlying investment is worth buying.
Arlen Dahlin, a 39-year-old Edmonton native, has learned that lesson well. Nine years ago he noticed an ad in his local paper for a seminar on real estate investing. Dahlin credits that seminar, given by a group called the Real Estate Investment Network, with changing his life.
After attending the seminar, Dahlin began looking for what he calls "money partners" — typically small business owners who spend all their time running their own firms. He was interested in finding people who were interested in investing in real estate but who don't want the headaches of managing them or dealing with tenants. "It may sound oversimplified," says Dahlin, "but I just kept talking about potential real estate deals to anyone who would listen. If I saw that they were even the least bit interested, I just kept right on talking."
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