What is good and what is bad debt?
Many people think that all debt is bad. While this is often true, there is such a thing as good and bad debt. It is important to understand the difference.
Debt, in general, costs money. The less debt the better. There are certain times that debt cannot be avoided. Buying a car with cash is difficult for most people. A house is another time that many people borrow money and get into debt. Student loans are another example of a time where debt might be hard to avoid.
What is debt?
Debt is when you purchase something, pay for a service (such as education), or borrow money and pay it back over some time. Credit cards, loans, and store accounts are all examples of debt.
Most will charge you interest which means that you pay back much more than the amount they gave you to start with. Interest is a fee that banks or lenders charge to make a profit from giving you the money upfront. They take a bit of a risk and they charge for that.
There are often many additional charges that are added on to the amount.
What is good debt?
Simply put, good debt is when you get into debt for something that will make you more money in the future. Investing in a good education, university, college, or even online courses, are good debt. They should allow you to earn more money or run your business better which will mean more money will come in than what you spent on the debt.
- Home loans
A home loan is normally an example of good debt provided you are careful. You want to buy a house in the right area and at the right price. In this case, the value of the house will (hopefully) go up over time so even though you are paying interest on the loan, in the long term you should still make money. This can take time so you need to keep the house for a while.
There are many other costs when buying a house so make sure you understand all of them and have the money to pay for them. It is always best to save a bit for a deposit before buying a house.
Another good idea is to try to pay a bit more into the bond every month, even if it is a small amount. This will save you a lot of money over time as you will pay less interest. We will talk about interest rates later but it important to have a good financial history to secure a better interest rate.
- Car loans (vehicle finance)
A loan for a car, or vehicle finance, can be good or bad. Most people need a car to do business or simply to get to work and back. This means that the money you are spending on interest is helping you make money.
You have to be careful, however. Buy a car that is affordable and does not cost a lot to maintain and repair. Some cars are much more affordable to maintain than other models. Petrol and diesel are expensive so you want something that is light on fuel.
The vehicle must also be suitable for your purpose. It is a good idea to service it according to recommendations as this will reduce the long-term maintenance costs. Insurance is also important. Shop around for the best rates but go with a company you can trust.
What you have to understand is that while a car might be necessary, it will go down in value over time, unlike a house. If you buy a new car, it will go down as soon as you drive it away. Some cars go down in value (depreciate) more than others. If you look at the market, you should get an idea of which cars are popular and these will drop less in value.
- Debt consolidation loans
Another debt that could be good, but is sometimes bad, is a debt consolidation loan. If you have debt with a number of different banks and other companies at a high interest rate, it might make sense to borrow money to pay off all the debts and repay at a lower interest rate.
You really have to do your homework here. These loans a normally paid off over a longer time so even though the interest rate is lower, you might still end up paying off more than you would if you stayed with the original debt.
You need to work out the total cost of each debt and compare it to the total cost of the consolidated loan to see if it will save you money or cost you more.
- Business loans
If you have to borrow money to grow your business this is good debt provided it is done with caution. If you make more from the loan than the interest payments it is good.
What is bad debt?
Bad debt is when you borrow money and pay interest on something that goes down in value and does not help you make more money. It often involves things or events that are gone before you even start paying off the debt.
- Credit cards
This is one of the biggest problems. People often use credit cards to pay for things that they might not be able to afford at the time. A credit card makes this easy but you will spend time paying it back and waste a lot of money on interest charges. Only buy something or enjoy an experience such as a meal out if you have the cash to pay for it.
One exception is buying bigger items such as furniture or electronics. If you really need a new fridge or TV, for example, it is often less expensive to buy it on your credit card than to take the instore finance. Compare the two options carefully.
If you must use your credit card, try to pay all or most of the balance every month and make sure you take advantage of the loyalty rewards that most banks offer.
- Store cards
The same applies to store cards. Most people will buy more than they can afford because they only have to pay it later. This is a trap that will cost you a lot of money. Try to avoid them.
- Borrow to invest
This is extremely risky and not a good idea. There are very few sure bets and borrowing money to invest is the same as gambling. There is a chance you will make money but probably a much bigger chance you will lose. Don’t do it.
How to minimize debt
While this is subject for a whole new discussion, there are a few things to take note of. A good credit history and credit score will allow you to shop around for a lower interest rate which will save you money.
If you have debt, make a plan and a budget to pay it off as quickly as possible. Pay off the debt that charges the highest interest rate first.
Final thoughts
Debt can be both good and bad. While it is ideal to live without debt this is not always possible. Try to only take on good debt and avoid bad debt.
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