Not all debt is created equal. When taking out a loan or buying on credit, it's wise to consider whether the debt will be "good" or "bad." Good debt can actually help you build wealth and better yourself. Bad debt, like credit card debt, has no potential to increase in value. Mortgages are often classified as good debt for several reasons, including low-interest rates, affordable payments, and the potential for the home to increase in value over time.
Here's why it's important to understand the difference between good and bad debt and why a home loan is a smart investment.
Good Debt vs. Bad Debt
Good debt can be defined many ways. It can include debt for assets that increase in value or bring in passive income, such as a home or rental property. Good debt can also increase your potential income, such as student loan to get a college education. Even a car loan can be good debt, even though vehicles lose value over time, if it's reasonable and allows you to work. Sometimes good debt is simply low-interest debt such as a home equity loan, which has a much better interest rate than other forms.
Bad debt, on the other hand, is debt you incur to buy things that lose value and cannot generate income or wealth. Bad debt is also considered any high-interest debt like credit cards. As a rule of thumb, this should be avoided as much as possible.
What Makes a Mortgage Good Debt?
There may be no better debt you can take out than a home loan. After all, you must live somewhere. Instead of paying rent, a mortgage allows you to invest in a home of your own that will grow in value over time and build equity. Average rent continues to rise year after year with the average rent for a two-bedroom apartment recently reaching $1,250 in Calgary. While you have no control over rent hikes, you can control your housing costs with a mortgage.
Here are the many ways a mortgage can pay off:
Homes Increase in Value
Real estate tends to increase in value with a proven track record over the long term. When it's eventually time for you to move on and buy a different home, there's a good chance your home will be worth more than you paid. You can't say this about your car, furniture, or electronics.
When you do sell your home, you won't even pay capital gains taxes on your profit.
Your Home Builds Equity
The difference between your mortgage balance and the value of your home is your equity. Every mortgage payment you make goes toward paying off your loan balance and increasing your equity. Your equity also increases when the value of your home increases. You can access this equity in a couple of ways. If you sell your home, you'll walk away with the equity you have left after closing costs. You can also borrow against your equity to make home improvements or cover an emergency.
Your equity doesn't just give you access to money in an emergency; home equity loans and lines of credit (HELOCs) are also considered good debt because they tend to have very low interest rates. A HELOC or home equity loan can also be used to pay off high-interest debt like credit cards to help you get rid of bad debt and lower your living expenses.
You can also refinance your home to access the equity and potentially reduce your interest rate.
Real Estate Is a Hedge Against Inflation
Inflation refers to the steady increase in prices and reduced purchasing power of money over time. Inflation also increases your cost of living over time. While a gallon of milk may have cost $1.15 in 1970, it would cost around $4 today thanks to inflation.
Real estate is one of the only assets you can buy that responds proportionately to inflation. When inflation increases, so does the value of your home. If you put money in a savings account, the interest you earn is unlikely to keep up with inflation, which means the money you put in will actually be worth less when you take the money out down the road.
Interest Rates Are Low
Mortgages have lower interest rates than most forms of debt. Avoid mortgage mistakes and you have an excellent opportunity to invest in real estate as the gains in your home's value can exceed the interest you pay over time.
A Mortgage Frees Up Money
Most Canadians can't afford to buy a home in cash, but it's not always a wise investment even when it's possible. Because mortgages have low interest rates and require fairly low down payments, financing your home can allow you to invest your money in other opportunities such as retirement. You can also inquire about the faster path to paying off a mortgage if you have the means to accelerate your payments.
There's no better debt than a mortgage. Taking out a mortgage to buy a home usually pays off in more ways than one. Your monthly housing payments will be working for you, unlike rent payments, which only help your landlord build wealth. Your home will also become an asset that can grow in value and give you access to low-interest home equity loans in the future.
With all that being said, taking on other forms of debt can be unavoidable. Learn about how to manage a mortgage while paying off other debts.