For many clients, the thought of landing in the red is enough to make them sick to their stomach. What most may not be aware of, though, is that not all debt is bad debt.

“Any debt where you can write off interest is good debt and any debt where you can’t write off interest is bad debt,” says Ted Rechtshaffen, president and CEO of Toronto-based TriDelta Financial Partners. “Any debt that’s at a very low interest rate can be good debt, too.”

Figuring out what’s good and what’s bad isn’t easy, though, as many cash-conscious clients are hard-wired to avoid owing money. Of course, high-interest credit cards can run someone into major financial trouble, but dismissing credit outright is foolish. “Credit cards are not a bad thing,” says Laurie Campbell, executive director at Credit Canada in Toronto. “It’s not a bad way to finance something, and it’s difficult to live without one.”

While it seems obvious, it’s imperative to pay off a credit card every month. It’s something many clients don’t do, though, and that’s when good credit turns into something ugly.

“Credit cards can offer convenience,” says Patricia Lovett-Reid, senior vice-president with TD Waterhouse Canada. “However, when that extra purchase comes through, and the client says they’re going to pay it off next month, it can get to the point when debt payments become so large that they’re digging into a household budget.”

While credit cards can’t do much besides allow a client to purchase a big-screen TV without dealing in cash, other forms of debt can actually help reduce taxes. Rechtshaffen explains that if someone borrows money for an income-generating venture, the interest on that loan is tax-deductible.

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“The main cases of that would be borrowing to invest in a non-registered account or borrowing to buy income-producing real estate,” he says. “If a client rents out a basement, they can write off a third of the mortgage interest.”

Simply taking out a mortgage in order to buy a house is usually considered good debt, but financing a home, even if it will increase in value over time, can go awry. Increasing interest rates, for one, can be detrimental to mortgage payments. Campbell says if rates rise, “it could turn into bad debt if you can’t keep up.”

As well, if a client wants to buy that dream house but ends up scraping by in other areas of his or her life, then the good debt turns bad. “If I’m in a financial position to manage debt comfortably, then a mortgage might be good debt,” says Rechtshaffen. “Personal real estate is, generally speaking, a good investment and a tax shelter, but if the client is eating cat food and sitting on crates, then it’s bad because they can’t support that debt.”

While mortgage and credit card debt are the most common, there are other reasons to go into the red. Improving “human capital” as Lovett-Reid puts it, for example, is one good reason for taking out a loan. “These are investments for the future,” she says.

The most common way people prop up their human capital is through education, so student loans are often considered good debt. “After someone graduates, they’re in a position where they will have a job and because income will be higher with education, a client can repay that debt,” says Campbell. “When it goes wrong is when you ignore that debt, and it goes into collections.”

Improving investment fortunes is another, and much riskier, way to get a positive return on a loan. With so many companies offering leveraged investment options these days, many people are asking advisors if taking out a loan to fund a stock purchase is the right thing to do. “Usually people who ask that are the ones we convince not to,” says Rechtshaffen. “And it’s not because theoretically it doesn’t make sense, but investors needs to be aware of the risk and be able to deal with it if it doesn’t work out so well.”

He says leveraged investing is for people with significant assets in real estate who can use their real estate equity more effectively.

Campbell agrees that investment loans aren’t just for anyone. She adds that in today’s unstable market climate, landing that positive return is increasingly more difficult. “There are no guaranteed wins,” she says. “There’s always going to be success stories out there, but for each success, there are 10 horror stories. It takes a savvy investor who can watch the markets every single moment of the day.”

Loans aren’t always about going into debt; Rechtshaffen says that borrowing money is a good way to improve a client’s wealth. He says someone with a net worth of $2 million who has $500,000 in debt-free real estate, another half a million in investment assets and no debt at all is facing some significant risks.

“There’s real risk because you are overly concentrated in real estate, and you want to have greater diversification,” he explains. “One of the ways to do that without selling real estate is to borrow some money against the property.”

In one example, Rechtshaffen says a person who owns a home, has money in an RSP but is without non-registered cash has a diversification problem, especially if the real estate market goes down. “Their whole net worth is going to drop, and these people also have a cash flow problem,” he explains.

To deal with that, Rechtshaffen suggests taking out a $500,000 mortgage and investing it. “They’ve taken care of the cash flow problem, they haven’t had to sell the house, and their overall portfolio is much more diversified depending how they invest it.”

However your client chooses to handle debt, having too much of it, no matter what, is always a bad thing.

“Whatever the debt is, find out if the client is paying the least amount possible,” says Rechtshaffen. “Is there an opportunity to make some of it tax deductible, and is it manageable? If someone has too much debt, you might have to put them on a debt diet.”

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(04/08/08)

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Originally published on Advisor.ca