Good Debt vs Bad Debt
An age-old question homeowners ask themselves is “should we go into debt to get out of debt?” A better question would be “should we use leverage to get out of debt?”
If done correctly, equity can be a very useful tool to leverage a homeowner’s ability to get out of costly debt. Leveraging debt can work to your advantage, and remains a viable option for those wishing to access their homes hidden equity to minimize their debt exposure.
The caveat here is that this strategy doesn’t necessarily work for everyone and is dependent on your specific debt situation. Be sure to take a good hard look at things like the length of time you plan to stay in your home, the actual cost of servicing your bad debt through traditional means, the impact of refinancing on your debt service ratio, and your expectations of the general future market trend.
If you are considering leveraging equity to pay off bad debt, there are several options you should consider before taking this big step. Among others, some options include taking out a 2nd mortgage on your home-sweet-home, equity refinance, Home Equity Line of Credit (HELOC) and an unsecured LOC, to name a few. This article will focus on Equity Refinancing.
Before we can talk about debt leveraging, though, we need to have a basic understanding of ‘good’ versus ‘bad’ debt. ‘Good’ debt is investing borrowed assets to purchase items that appreciate or go up in value. Using borrowed money to invest in residential real estate, starting a new business, or replacing higher interest rate credit card debt with lower rate options would be typical examples of leveraging good debt.
Using a home equity line-of-credit (HELOC) with a low interest rate (usually at prime) to pay off a credit card balance currently charging 19% interest is considered ‘Good’ debt. ‘Bad’ debt, on the other hand, is using borrowed money to buy a depreciating asset, or anything that loses value.
Examples of the use of bad debt are borrowing money to purchase a car that is worth considerably less once you drive it off the dealer’s lot, or not paying off your credit card balance in full every month. A word of caution is necessary here to clarify that not all car loans are ‘bad’ debt. If you use your car in your business (i.e., salesman, courier), then you obviously need your car to make a living. Alternatively, if you buy a big-screen TV to watch the hockey game, pay for it using your credit card, and pay nothing but the minimum amount each month, that’s bad debt.
Now that we’ve got that straight, properly utilizing home equity (…defined as the difference between the market value of your home and the unpaid mortgage balance) is a great way to leverage good debt. Refinancing your home to reduce monthly payments with a lower interest rate or to access cash that was locked in as equity to pay off bad debt can be referred to as good debt.
Of course, your home first needs to have sufficient equity in order to do this. Although lenders will require that a formal appraisal first be completed on your home, you can estimate your homes current market value by noting the average recent sale prices of similar homes in your community.
The difference between the homes appraised value and your current mortgage amount (i.e., Loan-to-Value) is the amount of total equity in your home. In a mortgage refinance, though, you are restricted by the lenders acceptable loan-to-value (LTV) tolerance, based on its acceptable risk appetite.
Most lenders limit your equity payout to 85% or less of the homes appraised value. So your available equity is the difference between the current mortgage balance and 85% of the current appraised value of your home.
Now with any loan negotiation, it only makes sense to refinance your home if it puts you ahead. If you currently cannot keep up with paying down your bills, and the refinance doesn’t lower your payments, it may not be a worthwhile endeavour. This is just stalling the inevitable and may require some tough decisions on your part.
Part of the brokers job is to assess your family debt servicing position to ensure you are not spending too much of your income on your mortgage. According to Credit Counselling Canada, your spending breakdown as a percent of your income should approximate:
* 35% – Housing expenses (rent/mortgage, insurance)
* 15% – Debts (credit cards, car loans)
* 15% – Utilities
* 10% – Savings
* 25% – Daily living expenses
Beyond the broker’s calculations, though, you should always make sure that your own budget is sufficient to absorb any new costs and payments that result from your refinance. A qualified financial planner or credit counsellor can assist in helping you determine your personal budget.