Debt doesn’t have to be a big scary word – if you’re using it to build wealth and invest in your future. But how do you know if you have too much debt? Which debts will benefit you (or harm you) in the long run?
Let’s consider three popular types of debt: credit card debt, personal loans and mortgage debt.
1. Credit Card Debt
Let’s start with the easiest: credit card debt. Credit cards can make your life a whole lot easier, letting you make big purchases on the go or online. Indeed almost all online transactions require the use of a credit card.
The rule is simple: pay off the full balance of your card every month. If you can’t, you’re spending unwisely. Credit card interest rates are very high, often over 20% per year. Their use requires iron discipline. Credit card providers know this, and are banking on your inability to control your spending to line their pockets with very high interest. If you consistently exceed your ability to pay your full balance, you could fall into an interest-rate trap that is costly to pay.
2. Personal Loans
Typically a personal loan is contracted at a more reasonable rate. Sometimes, it can be secured through a property. We use personal loans for a big purchases, like a car or home renovations. Ideally, it should be repaid before the end of the useful life of the financed asset. On the other hand, if you use a line of credit or a personal loan to finance the consumption of everyday goods – such as gifts, dining out or groceries – you are living beyond your means, and sooner or later, you risk paying the price.
3. Mortgage Debt
Mortgages can be considered good debt since they allow for the purchase of a property. When you buy a house and as you pay off your mortgage over time, you end up richer by creating what is called equity in your wealth. Home equity is simply defined by the value of the latter minus the value of the mortgage.
But be careful – just because the bank has approved a mortgage for you, doesn’t mean you have to take it. It is in their best interest that you take on as much debt as the banking rules allow.
Did you know that the interest cost of a mortgage loan can be as high as the amount borrowed under the mortgage during the term of the loan? For example, if you borrow $500,000 on a mortgage that is amortized over 25 years at a rate of 6.5% with monthly payments, you will have to pay $1,012,811 to settle your debt, over the 25 years – yes, that is more than a million dollars – which is more than double the capital borrowed! It’s like paying for your house twice! Moreover, if rates were to continue to rise as they did in the 1980s when rates were around 20%, then more than five times the value of the amount borrowed would have to be paid.
Seen another way, when we calculate the mortgage cost, using a rate of 5%, which represents approximately the 5-year rate that is currently in effect, we obtain a cost of $376,885 in interest. If you decide to reduce your loan by $100,000 to finance a cheaper house, say $400,000, that would be about $75,000 that you would save in interest and which could be invested in an RRSP or a TFSA to grow the net worth of your household.
But when do you know if you have too much debt? When the amount owed prevents you from achieving your financial goals, such as investing for your retirement, saving for projects or creating an emergency fund. If your debts are preventing you from paying your daily bills, you are approaching the precipice and it is high time to consult a financial advisor to quickly assess your options.
Finally, consider that the maximum amount offered as a loan by the bank is exactly that: it is the maximum amount of debt you can have according to banking rules. And if you are using the maximum you are allowed to borrow, for example for a mortgage loan, it is very likely that you have “too much” debt.