Good Debt vs Bad Debt
Not all debt is bad.
It is worth knowing the difference between good debt and bad debt before you borrow money.
What is good debt?
In simple terms, a good debt is one that is a sensible investment in your financial future.
You should be better off in the longer term and should still be easily affordable if there is a change in your current circumstances. If for example you are off work for a couple of months.
You will have a clear and specific reason for taking it out, and a realistic plan for paying it back that allows you to clear the debt as quickly as possible. In a series of regular and affordable payments (e.g. for a mortgage).
When you are looking to take out a good debt, like a mortgage or a car loan it is important to shop around for the right type of debt and consider all the options.
For example, a loan secured on your home may offer much better rates of interest, but your home may be at risk if you miss payments.
Examples of Good Debt
Here are some examples of good debt that may make you better off in the long run:
- A mortgage can be a good debt as it enables you to buy a home to live in. Once the mortgage is paid off, that home will be a big financial asset which is likely to grow in value over time. Monthly mortgage payments can be cheaper than rent.
- Buying a car you can afford. If it is essential for you to get to work and earn a living. However, it’s important to consider the loan costs and the running costs of the car out of your income.
- Investing in your own business. A loan to help develop your own business can be a good investment if you have a sensible business plan. If your business does well it will end up being worth far more than the loan you originally took out.
- A Student Loan. Taking out a student loan to pay for a University course can be a great investment in yourself (It paid HUGE dividends for me!!) Graduates typically earn more than non-graduates. A student loan from the Student Loan Company is a government loan. It will not impact your credit score. You will only have to repay the loan once you are earning more than a certain amount. It’s worth remembering that any student loan repayments will be taken into consideration when you apply for a mortgage in the future though.
What is Bad Debt?
Bad debts are those that drain you. They are not affordable and offer no real prospect of ‘paying for themselves’ in the future.
Bad debts are often taken on impulse or luxury purposes. Items either aren’t really needed or are further credit to fund everyday bills.
If you can’t afford to borrow the money (for example you are not sure you’ll be able to make the monthly repayments) it’s definitely a bad debt.
Examples of Bad Debt
Here are some examples you should consider twice before taking on.
If you can’t pay the debt off in the short term, walk away. Trust me it will save you so much stress and anxiety in the future.
- Borrowing money to pay bills and or credit debts. If you are struggling to get to the end of the month, putting more and more every day bills on credit cards. Stop. Don’t be tempted to borrow even more. Look at your budget. Get free confidential advice. You can turn things around. Now. Before they get out of control.
- A luxury holiday. A luxury holiday can be a trip of a lifetime but it’s 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, just one you can afford.
- A brand new car. If you don’t need to buy a new car think twice about it. New cars lose a lot of value and if for example, you lose your job and you were unable to keep up repayments, you may end up out of pocket. Unable to afford or sell the car. Possibly losing the car and still owing money.
Tips to Avoid Bad Debt
When considering borrowing money ask yourself the following questions.
- Have I shopped around for the best deal?
- Am I borrowing more than I need?
- Am I borrowing this money as cheaply as possible?
- Will I be able to afford the repayments in interest rates rise in the future?
- Do I really need it now?
- Will I be able to manage if my circumstances change?
- Do I understand the terms and conditions associated with taking out this finance?
- Will I comfortably be able to afford the repayments?
- Can I wait a couple of months and save towards this?
- Will borrowing this money improve my finances in the long run?
- Do I understand the risks and what could happen if things go wrong?
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.