What do you consider when taking on debt to finance a large purchase? You likely consider the terms associated with your loan and the strain that will be placed on your financial position. In addition, you will most likely develop a future repayment strategy.
But do you consider whether the asset you will be purchasing is a good or bad asset? Additionally, do you consider whether you’re taking on good or bad debt?
To determine whether the asset you’re purchasing is good or bad, there are two things to consider. You must determine whether the asset appreciates or depreciates over time and if the asset generates income.
Based on how the asset scores, you can then determine if you are taking on good or bad debt. Good debt is debt that’s used to purchase a good asset that appreciates and generates income. Debt incurred to purchase assets that depreciate or do not generate income is considered bad debt.
Let’s take a look at the different kinds of good and bad assets.
Your biggest asset is, well, you! If you take out $30,000 to pay for your post-secondary education, you are making an investment into your future through good debt. Although your education will not generate any financial return short-term, upon graduating, you will likely qualify for higher-paying jobs. Therefore, you are able to leverage your knowledge to succeed in your chosen field.
Investments, whether through your RRSP, TFSA, or unregistered investment accounts, are often considered good assets. Investments tend to appreciate in value over time. Smart investments can also help you protect yourself from inflation (which can reduce the purchasing power of cash). It is important to note that investments can increase and decrease over time. However, good investments will produce returns through appreciation, dividends, and benefit from growth through compound interest!
Real estate, similar to investments, is a good asset. Generally speaking, land tends to appreciate over time, so by purchasing a home, you are making an investment in a property that will likely sell for more than you purchased it for, rendering a home a good asset.
That being said, land can still depreciate in some cases as its value depends on the location and other variables. It’s important to do your research into neighbourhood trends and property value before making a purchase!
Unlike education and homes, a car is usually considered a bad asset. As soon as you drive off the lot, your car immediately loses value that can never be regained. Therefore, a car is a depreciating asset. When you go to sell your car in a few years, you will never regain your initial investment. Many of us require a car to go to work and run errands, however, it’s wise to purchase a car that does not require taking on significant debt so you can instead invest your money in good assets.
In some cases, a car can be considered a good asset. This is usually limited to antiques or classic cars, but this is a long shot that often comes down to luck!
It’s important to consider your interest rate when deciding if an asset qualifies as a good or bad asset. Even if the asset appreciates and generates income, if the interest rate tied to your debt exceeds the income generated from the asset, that asset would no longer be considered a good asset.
Since there are two qualifications to classify assets as good or bad, you may find yourself in a position where you’re considering an investment that qualifies in one category, but not the other.
For example, if you’re considering doing significant renovations to your home, you could say the asset is good as you will likely make a return on the renovations when you sell your home. However, the new furniture and furnishings you purchase will be depreciating assets. In addition, depending on your style choices, the renovations may suit your needs well but might be out of style when you decide to sell your home.
In this scenario, it’s important to consider which aspect outweighs the other. If you believe the renovations will generate such a sizable return that the depreciating assets do not greatly affect your financial situation, then you can qualify this as a good investment and take on good debt. However, if the renovations do not provide the necessary return, you may be better off avoiding renovations.
For example, turning your 90’s kitchen into a modern, desirable and stylish kitchen will significantly increase the value of your home. So will installing a heat pump or energy-efficient source of heating/cooling for your home. But switching out light fixtures, painting or doing some landscaping will likely not assist in appreciating the value of your home.
Know your assets!
Being conscious of purchasing good versus bad assets is critical for developing financial health. You want to purchase good assets and take on good debt as much as possible. Therefore, ensuring your investments are generating a positive return.
If you’re looking for further guidance on differentiating between good and bad assets, we are always willing to help answer your questions directly. You can give us a call at 506-854-6847 or you can get in touch with us here!