If you’re considering borrowing it’s beneficial to be able to recognise the difference between good debt and bad debt.
Whilst there are some things in life where taking out a debt can undoubtedly be a great investment in your long term financial well-being, there are others that can leave your long term outlook in tatters.
Arming yourself with the knowledge will prevent you from ending up knee deep in the brown stuff further down the line.
What is the difference between a good debt and a bad debt?
What is a good debt?
A simple explanation would be a sensible investment in your financial future that should leave you better off in the long term, leaving no negative impact on your overall financial position.
There should be a very specific and valid reason for taking it out with a sound and viable plan to pay it back, this way you can clear the debt as quickly as possible, or by making a series of regular affordable payments – for instance a mortgage.
In order to ensure you have a good debt you need to make sure you have identified the cheapest possible way of borrowing the money.
To do this you need to do a bit of research by finding the lender with the best borrowing method. Figure out exactly how much a potential loan or credit card is going to cost you in interest until paid back.
Don’t always assume that a loan would be less to pay in interest than a loan, depending on your credit score and interest free periods it may not always be the case.
Some typical examples of a good debt include:
- Student Loans – Taking out a student loan to pay you through university and graduating can be a great investment in your future. Graduates typically get paid more than non-graduates so you can count this as a sound investment. The interest rates are relatively low and you only have to start repaying the loan when you earn over a certain amount.
- Mortgage – A mortgage gives you the chance to buy your own home or investment property. Once the mortgage is paid back in full the property is a great long term financial asset, which going off recent trends is likely to grow in value over the years. It’s also better than paying off someone else’s mortgage for them in rental charges.
- Investing in your own business – If you are armed with a strong, realistic business plan and have the enthusiasm and work ethic to see it through a loan to set up your own business can be considered a sensible debt. If your business is a success you will end up earning far more than the loan you originally borrowed.
- Buying an affordable car – If a car is essential for you to get to work, an affordable car is a good investment. However, it’s important you can keep up with the repayments, as well as ensuring the associated costs of running the car do not take too much of a chunk out of your income.
What is a bad debt?
Bad debt is a drain on your wealth,has little prospect of paying for itself, or is simply not affordable.
They are likely to have no realistic repayment plan and are often run up when somebody makes impulse purchases over sensible ones, or have been borrowed to pay every day bills when we’ve maxed our budget.
If you have any doubts about being able to maintain the repayments it is definitely a bad debt!
Coming up are a list of debts that, in my humble opinion, you should definitely consider swerving.
- Luxury holidays – If that chance of a lifetime holiday is accompanied by years of debt then it should be avoided, plain and simple. Instead of plunging yourself into unnecessary debt try saving for it first, where possible adjusting your plans so you can still take the holiday, but one you know you can afford.
- Brand new cars – If you don’t need a car think twice before buying one. They lose a huge proportion of their value within the first year of purchasing them and have no resale value once purchased. If you fail to keep up with the repayments you could end up having to sell the car for less than the loan you took to pay for it in the first place. Even worse, the car could be repossessed leaving you with the debt and no car at all.
- Borrowing to pay bills – Robbing Peter to pay Paul will lead to certain disaster and is the quickest way to a debt solution further down the road. If you are struggling with the commitments you already have it is much better to seek debt advice to help get your finances back on track rather than attempting to borrow your way out of trouble.
Things to consider before you borrow any money
Ask yourself the following questions before you borrow money.
- Will it improve my finances in the long run?
- Have I got the best deal by shopping around?
- Am I borrowing as cheaply as I possibly can?
- If the interest rate rises would I still cope with the repayments?
- Are the monthly payments 100% affordable?
- Do I understand the associated terms and conditions of the credit agreement?
- Am I aware of any potential risks should anything go wrong?
How much money should I borrow?
Once you are certain the debt you are taking on is a good debt, you need to work out exactly what amount to borrow. It is important not to get greedy and only borrow what is affordable to you. Borrowing more than you need can turn a good debt bad in no time at all!
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