As an increasing number of credit streams become available to the modern consumer, the lines between what constitutes a ‘good debt’ and a ‘bad debt’ have become increasingly blurred. In an ideal world we would never have to spend money we haven’t earned, but when it comes to mortgages and student loans, sometimes we need to borrow to help us get ahead.
One of the biggest financial lessons we need to learn is the difference between a good debt and a bad debt. The truth is that there are some things that are worth getting in debt for. However, there are also plenty of other debts that will leave you in a big financial mess.
So how do you tell the difference between a good debt and a bad debt? Here’s our guide…
What is a good debt?
As wonderful as it would be to go through life without accumulating a penny of debt, for most of us that’s just not possible. The average household debt in the UK currently stands at £13,520. However, if we do our best to stick to the good debts, then at least every penny we owe will have helped us in some way.
A good debt is one that represents a sensible investment in your future. For example, a student loan is an example of a good debt, firstly because the loan itself is very cheap, but secondly because it contributes to your future. The idea is you’ll be able to get a better job, earn more, pay the debt off and have a prosperous future.
The same can be said for a mortgage. It allows us to purchase a home to live in and invest in a significant financial asset which is likely to grow in value over time. In many cases, monthly mortgage payments are also cheaper than paying rent, making this debt a no-brainer.
A good debt is one which:
- Is motivated by a clear and specific reason
- Has a realistic payment plan
- Is affordable
- Will help to improve your life
What is a bad debt?
On the other side of the coin we have bad debts. These are debts that drain your wealth rather than contributing to a more prosperous future. They are often the result of impulse decisions to purchase items we do not need. Examples of bad debt include a luxury holiday you really can’t afford, or a brand new car when you have a perfectly good one sitting one the drive.
In some cases, the reason people accumulate bad debt is simply because they do not possess the financial literacy to make sensible decisions. A recent survey by Wonga South Africa found that of 18,000 respondents, ‘only 43 percent knew what a credit report was, while 77 percent did not look at the interest rates or fees on credit applications.’ As a very simple rule for managing debt, if you can’t repay the money in the short-term, it’s probably better not to spend the money at all.
A bad debt is one which:
- Is more expensive than other potential sources of finance
- Does not have a realistic payment plan
- Does not put you in a better position than you were in before
- Has monthly repayments you’re going to struggle to afford
When a good debt becomes a bad debt
Once you have established that the reason you want to borrow the money constitutes a good debt, the next step is to calculate exactly how much you need to borrow, over what period of time and how you will pay it back. You should also factor in the cost of interest rate rises into your calculations and make sure these are affordable. If you do borrow money without having a plan in place to pay it back, your good debt can quickly turn bad.