Debt can be classified as either good or bad, but that doesn’t always mean that one form of debt is any worse for you than another. It is the way you use and manage debt which often defines whether it is a good idea or a bad idea for you to borrow more money.
The true definitions of good and bad debt can differ greatly depending on who you talk to and who you want to believe, for example good debt can be as narrowly defined as a loan you repay with your pre-tax dollars such as a margin loan, or as broadly as a loan with a low interest rate.
Therefore, here are a few of the most common ways you can define your own debt, and decide what sort of debt is good for you.
For some people it is hard to reconcile the idea of debt being good, especially if they have grown up through hard times, or listened to their parents intone about the virtues of saving up for something you want to buy. However, debt can be good when:
- It leads to something of value. If you are borrowing for a purpose which will result in increased wealth or assets then the debt can be considered good. For example, a student loan leads to good education and better job prospects to create wealth, while an investment loan or mortgage leads to an appreciating asset.
- You are borrowing for something which can be sold at a profit. This means your home loan, investment loan or margin loan have the potential to be good debt because the assets you are buying with the borrowings can be sold for a profit if managed correctly.
- You are borrowing for an income generating asset. Usually you are the one paying your loan off from your own funds, but when the asset you have bought with that loan pays you in the form of dividends or rental income then you can be in good debt.
- It has a low interest rate. If you are in debt, you should make sure it is the most affordable form of debt, so a good loan is one with a low interest rate.
The benefits of good debt include:
- Increasing your net worth. Your net worth is the difference between what you own and what you owe, and if the assets you owe money on are increasing in value, your net worth increases, making the debt worthwhile. As a result, you grow your asset base, and can even use that equity to diversify your investments for greater stability.
- Achieving your goals. When you borrow money to make an investment in your future, you are able to work towards achieving your goals, whether you grow a business or invest in property, or in yourself.
- Building up a good credit report. Whenever you apply for a new loan or credit card, your credit report will be reviewed, and the amount of good debt you have can actually work in your favour for approval, as it shows you are responsible and make smart investments with your money.
Make sure you are aware of the drawbacks of good debt, including:
- Remember it has to be repaid. The debt is good, it’s not magical and it does still need to be paid each month, on time to avoid default. Don’t be lulled into thinking there aren’t consequences for missing a payment because your good debt can quickly go bad if it is mismanaged.
Bad debt is more a classification of a type of debt, rather than a specific loan because without the proper understanding and management, any form of debt can go bad. However, when looking at forms of debt which are opposite to good debt, there are certain features of bad debt you will want to avoid, including:
- A high interest rate. When you have a higher interest rate applied to your debt, you are making higher monthly repayments, and therefore working harder to repay the loan. This means that you need to see an even greater benefit from the loan to make these extra costs worthwhile.
- Purchasing disposable items of depreciating value. Often bad debt such as credit cards and personal loans are used to buy highly disposable items which do not increase in value and have a low resale value. That means you are paying more through a high interest rate, for an item which is worth less than when you bought it.
- Not paid in full. Bad debt is often on a revolving cycle which compounds the amount of interest you are paying, making it harder and harder to repay the debt in full – plus, since the assets you have purchased with the debt have depreciated, the sale of these assets will not cover the loan amount as they would with an investment property for example, and the debt must be repaid in full from your own funds.
Bad debt is not all bad and does offer benefits including:
- Credit cards can be used for business expenses. If you are starting up a small business, a credit card may be the only form of borrowing you are eligible for, and can help you make initial lease payments on premises, purchase stock and office equipment and give your business the professional start up look it needs for success.
- Credit cards can facilitate cash flow. If you struggle with cash flow because of emergency expenses or the unpredictability of contract work payment, then a credit card can help you pay your bills in the interim, so you don’t get behind or ruin your credit rating.
- Car leases can offer tax benefits. If you lease a car – which is a depreciating asset – and pay interest on the lease, you can actually reap the benefits at tax time by being able to claim the expenses against your income tax or on your business tax return.
- You enjoy the use of the items purchased. Bad debt such as a credit card or car loan allows you to obtain an item you need, which you can’t wait to save up for – think about all the use you get out of your car over the term of a car loan, compared to how long it would have taken for you to buy the vehicle outright, and you’d be catching the bus everywhere until then.
Bad debt is not without bad features, so make sure to watch out for:
- A high interest rate. Bad debt such as credit cards or store cards is unsecured debt as the purchases you make with the credit are not held as security over the loan in the same way as a house or car are. This makes for a higher interest rate which can make it even harder to repay the debt in full, leading to compounding interest and a revolving cycle of bad debt.
- You are not growing your wealth. While you may be making your life easier using bad debt to fund your purchases, always be aware that you are not growing your wealth and you will need to have financial plans in place to ensure not all of your money goes towards servicing bad debt.
- Can impede your borrowing power. When you have bad debts listed on your credit report it can make you an unattractive candidate for other borrowings such as a home loan or personal loan, which can again stop you from growing your wealth.
Alban is a personal finance writer at Home Loan Finder, a home loan comparison website.