Before you borrow money or if you have already borrowed money it’s important to know the difference between good debt and bad debt. Some debt will leave you in an extremely difficult financial position whilst other debt can be worth it and easier to manage.
Before we go any further I will clarify that this does not constitute as financial advice and you should seek financial advice.
What is good debt?
This will vary from person to person but generally it is a sensible investment for your future with a goal to leave you in better off financial position.
You will have a concise reason for taking out the debt and realistic plan for paying you back in the quickest but also affordable and regular instalments.
Good debt can also be aligned with sourcing the the cheapest way possible (to a certain extent) of borrowing the money.
They’ll have done this by finding the borrowing method, an interest rate, loan or credit amount, term and charges that are the most appropriate for them.
In some cases it will mean a deal with the lowest possible interest rate, but in others it might not.
For example if the lowest rate comes with the price of high charges or penalties.
Examples of good debt
- A loan for education: The traditional model to this was a student loan, however due to rising costs people are now seeking other methods such as accountancy courses and any other professions that require qualifications to demonstrate a level of competency. Typically these are good investments because after you graduate/qualify you will expect to earn more than if you hadn’t done it. Additionally with student loans the interest is generally low and repayment isn’t required until you hit a threshold of income.
- Mortgage: a mortgage can be a good debt, because it will enable you to purchase a home to live in. Once that mortgage is paid off, that home will be a big financial asset, which is likely to grow in value over time and the monthly mortgage payments could be cheaper than rent.
- Investing in your own business: a loan to help you develop your own business can also be a good debt, as long as you have a sensible and realistic business plan. If your business does well it will end up being worth far more than the loan you originally took out.
- Buying a car you can afford: if it is essential to enable you to get to work and earn a living. However it’s important that you can afford the loan repayment costs and the running costs of the car out of your income.
What is bad debt?
Bad debt is anything that drains your wealth, offer no prospects of paying for themselves in the future and are not affordable.
They often have no realistic repayment plans and are run up when impulse purchases are made for items they don’t really need. They can also be when money is borrowed to pay for every day bills.
If you can’t afford to borrow the money (for example, you aren’t sure you’ll be able to make the monthly repayments) it is definitely a bad debt.
Examples of bad debt
If you can’t pay the debt off in the very short term, it’s probably better not spending the money.
- A luxury holiday you can’t afford: a luxury holiday can be a trip of a lifetime, but is best avoided if it’s accompanied by a lifetime of debt. Instead of getting into debt, try and save up first, if necessary reworking your plans so you can still take a holiday, but one you can afford.
- A brand new car you don’t need: If you don’t need to buy a new car, think twice about it. New cars always lose their value and if you lost your job for example and you couldn’t keep up the repayments, you might end up with a loan for more than you could sell the car for. That means you’d have no car but an outstanding debt (and interest) to pay.
- Borrowing money to pay bills and or other credit: if you’re struggling to get to the end of the month you seek professional advice, which will help you get your finances back on track.
Tips to avoid bad debt
When considering borrowing money, ask yourself the following questions.
If any of the answers are ‘no’, that debt is likely to be bad.
- Have I shopped around to get the best deal?
- Am i borrowing this money as cheaply as possible?
- Will I be able to cope should interest rates rise in the future?
- Will I comfortably be able to afford the monthly repayments?
- Will borrowing this money improve my finances in the long run?
- Do I understand the risks and what could happen if things go wrong?
- Do I understand all the terms and conditions associated with borrowing this money?
How much should I borrow?
Once you have established that the money you want to borrow is a good debt, you need to work out exactly how much to borrow and how you’re going to pay it back.
Borrowing more than you need without a plan for paying it back, can swiftly turn a good debt bad.