If you’re considering borrowing, it’s most certainly of benefit to know the difference between good and bad debt. There are some things in life that is worth temporarily putting yourself in debt for, whilst other can leave you in financial ruin. I’m going to show you the difference.
Good Debt vs Bad Debt…..
What is good debt?
In Layman’s terms, it is a sensible investment in your financial future, should leave you better off in the long-term and in no way should have a negative impact on your overall financial position.
You should have a specific, valid reason for taking it out with a sound plan to pay it back, allowing you to clear the debt as quickly as possible, or by making a series of regular affordable payments – for instance a mortgage.
Anybody with good debt will have already identified the cheapest possible way of borrowing the money by finding a lender with the best borrowing method, an interest rate, credit or loan amount, terms and charges that are most befitting to their needs.
Here are some typical examples of a good debt and why:
- Student Loans. Taking out a student loan to pay you through university will help you achieve the goal of becoming a graduate. Graduates typically get paid more than non-graduates so you can count this as a good investment in your future. 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 will enable you to purchase your own home to live in. Once you have paid back the mortgage, the home will be a financial asset, which is likely to grow in value over the years. It is also better than paying off someone else’s mortgage for them in rental charges.
- Invest in your own business. If you are armed with a strong, realistic business plan, a loan to set up your own business can be a good 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 and earn some money, an affordable car is a good investment. However, it’s important you can keep up with the payments, 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?
A bad debt is a drain on your wealth, have no prospects of paying for themselves or are not affordable.
They are likely to have no realistic repayment plan, and are often run up when somebody makes impulse purchases rather than sensible ones, or have been borrowed to pay every day bills.
If you feel unsure you can make the repayments it is definitely a bad debt!
The following debts you should think long and hard about before taking them out. If you are unable to pay off the debt in the VERY short term, it’s money you probably shouldn’t be spending.
- Luxury holidays. If that chance of a lifetime holiday is accompanied by a lifetime of debt then it should be avoided. 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 card, 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. 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. Even worse, the car could be repossessed leaving you with the debt and no car at all.
- Borrowing to pay bills. Or robbing Peter to pay Paul as I like to call it. It is a recipe for disaster and the fastest way to a debt solution. 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
Ask yourself the following questions before you borrow money. If any of the answers are ‘no’, that is highly likely to be a bad debt.
- 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?
What 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 quickly!
Do you have any tips for borrowing?
He is also a contributor to Clear Debt, ICOUNT Money and M1 Debt Advice blogs discussing all things personal finance.