‘Good’ debt and bad debt — how to tell the difference
A clever fellow called Josh Billings — the pen name for 19th century US humourist Henry Wheeler Shaw — once wrote: ‘Debt is like any other trap, easy enough to get into, but hard enough to get out of.’
It’s the truth. There’s actually no such thing as ‘good’ debt, it’s just that some loans make more sense than others. For example, a home loan on a property that you’ll live in for many years, and which will hopefully increase in value, is better than a short-term loan for the latest pair of Air Jordans.
The key is to be able to tell the difference. Here’s your guide.
Will the purchase increase in value over time, potentially generate an income, or become an asset? Will this debt contribute to your quality of life in the long term? Here are some examples of ‘good’ debt:
• Buying property. Unless you have a very rich (and generous) uncle, most people have to go into debt to finance a property. But once a property is paid off, it becomes an asset, and it might increase in value over time, giving you the option of selling it for a profit. A property can also provide a rental income, or a space where you can live rent-free.
• Getting an education. With the ever-increasing cost of higher education, a student loan might be your only way to obtain a certain qualification. But it’s a good investment because you’ll hopefully increase your earning potential and open more doors for future employment.
• Starting a business. This one’s not so clear-cut. With a small business loan, you could take your side hustle off the ground and be your own boss, potentially increasing your earnings and your net worth. But in reality, it’s probably not that simple. Do proper research and a full risk assessment to determine the viability of your business plan before you sign any loan documents.
If you get into debt for a purchase that doesn’t check any of the ‘good’ debt checkboxes, it’s probably bad debt. Bad debt attracts a higher interest rate since it’s usually not tied to an asset that can be used for collateral and is therefore riskier for the lender. Here are two examples:
• Credit cards and store cards. If you pay off your credit card in full each month, all good. But if your spending gets out of hand, credit card debt has a very high interest rate and you’ll soon be in over your head. The same goes for a clothing or store account, which also has a high interest rate and a monthly service fee. When considering a purchase on credit, remember the golden rule: If you can’t afford it in cash, you probably shouldn’t pay for it with your card.
• Buying things you can’t afford. AKA reckless spending. The unchecked buying of luxury items and nonessentials on credit or account can lead to debt misery. This is why it’s so important to track your spending and create a budget using 22seven. Ask yourself: Is this a want or a need? Am I better off saving for this item, or just saving the money? Whether it’s clothes, holidays or entertainment, if you didn’t budget for it, you shouldn’t buy it on credit.
What about buying a car?
Good debt, bad debt? A car is a bit of both. Because it’s a depreciating asset, financing a car is bad debt, in theory. But a car can also improve your quality of life by getting you where you need to be safely. So, as long as you shop sensibly and you can afford your monthly vehicle payment, plus all the associated costs like petrol and insurance — and you’ve included those costs in your budget — it could be worth going ahead with the loan.
At the end of the day, it’s all about being conscious of your spending. Remember, your finances are within your control! With discipline and planning, you can grow your wealth, not your debt.