How Much Debt Is Too Much Debt?

debtObviously right now the Bank of Canada thinks that Canadians are in too much debt and a lot of officials agree. There is a lot of discussion on the news about there being too much debt and that’s why there have been changes to the mortgages rules – the government’s attempt to control you from accumulating too much debt.

Basically everywhere you look right now, people are talking about debt.

So How Much Is Too Much? 

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The answer is that it’s not about debt, it’s about what you have debt for. You will hear people talk, especially accountants, about good debt and bad debt or good interest versus bad interest.

Good debt would be something that you took on to acquire something with appreciating value and/or to give you a return.  This is potentially a rental property or business purchase or expansion.

Bad debt would be getting into debt to acquire something you are going to use up immediately and gain no future benefit from. This could be a vacation.

What’s Your Comfort Level? debt

It’s not just the amount of debt you have, it’s also about the comfort level you have with it and your ability to pay it all off in an emergency.

Let’s say you have a million dollars worth of debt and it’s against a building that’s worth 1.5 million. In the event of an emergency that requires you to sell that property immediately, is that good debt or bad debt? Chances are it’s okay debt, not necessarily good or bad.

If you rack your credit cards up buying clothes, gifts and going out for frequent expensive meals, you may soon realize you can’t make your payments at the 19-22% interest rate anymore. That is bad debt.

 

debtHow Much Debt Is Appropriate?

In short, the appropriate amount of debt is the amount that you are comfortable with in relation to the assets you own and the earnings that you generate from them.

If you’re looking to buy a home for yourself that you plan on living in, don’t overextend yourself just because you can borrow more money to buy a bigger and better house. If interest rates go up, you could end up in big trouble.

Don’t put yourself into that position.  Work on building up a cash reserve. Buy within your means and leave yourself some flexibility or risk overextending yourself into the danger zone.

 

Giving Yourself A Reserve

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When I’m doing my financial planning around debt and the acquisition of an asset, I generally use 7 or 8% interest rate on the acquisition. Even though interest rates are around 3-4% right now, I do that because it gives me flexibility to know that if interest rates do go up, I’ll be in a better position to figure out if the project still works.

You have to think ahead and consider your future cash flow. Are interest rates going to go up by 3.5% over the next 3 years? Probably not. Are rental rates going to go up over the next 3-5 years? Most likely.

You look at that and realize you have to renew in 5 years but your revenue has increased. The odds are that if interest rates have gone up, you’ll be comfortable with that and the investment still makes sense

Keep debt at a comfort able level while having flexibility, building in cash reserves and expect when you are planning that values of houses are going to go down. The only type of surprises you want are the positive ones!

 

 

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