Good debt vs Bad debt

I’m sure you would have heard people talking about good debt and bad debt and there are often conflicting opinions on this. I am not encouraging the use of debt but I do understand that sometimes one does need to make use of debt in order to accumulate wealth.

In this article I will explain the difference between good and bad debt and give you some examples of each. I will also discuss why the way in which you manage your debt can be the determining factor in whether it is regarded as good or bad debt. 

Let’s start off with bad debt. Bad debt is debt that is used to purchase things that depreciate in value or things that don’t give you a return.

Here are some examples:

• Store cards or accounts. These are usually offered by clothing or household stores and are quite easy to qualify for. The items that these stores sell don’t appreciate in value and don’t generally give you a return on your money so any debt used to purchase these items is bad debt. The interest rate on this debt can also be very high so it is advised to avoid it at all costs.

• Car loans. I understand that it is not always possible to buy a car cash and so car finance is often used. Cars generally depreciate in value and don’t give you a monthly return and so it is classified as bad debt. If it is managed correctly, it doesn’t have to be detrimental to your financial wellbeing. It is crucial that you don’t use car finance to purchase an overly expensive car. The key ideas of delayed gratification and living within your means must still be at the forefront of all your financial decisions.

• Personal loans. These loans can be used for anything, like to go on holiday, fund a wedding, make renovations or purchase something you actually can’t afford. Majority of these items or experiences will not give you a return on your money. These loans are also generally very easy to get as you often pre-qualify for them, but that doesn’t necessarily mean you can afford them.

On the contrary, good debt is debt that is used to purchase things that appreciate in value or that generate a return.

Here are some examples:

• Mortgage or bond on an investment property. Your investment property should generate a return as soon as you rent it out and hopefully the income will exceed your monthly bond repayments within the first few years. 

• Business loans. This form of debt should be carefully managed. You need to do a proper, thorough analysis before you take out a loan or go into debt for a business investment. The return on your business venture should be able to cover the loan repayments as soon as possible. 

In my opinion there are some debts that can be regarded as good and bad debt, depending on how they are used and managed. You are the one that determines whether the debt will be used to purchase something that appreciates in value and/or gives you a return, or not.  

Here are some examples:

• Credit cards. If credit cards are used correctly, they can be regarded as a good debt and can have a positive impact on your credit score. However, if you use your credit card to rack up a lot of debt by purchasing things you don’t actually need and you only repay the minimum amount each month, it can be very dangerous and can cause you to get stuck in debt. In order for a credit card to be regarded as good debt, there are 2 requirements. Firstly, you pay the full balance off monthly so you start each month with no money owing on your credit card and secondly, you use it for the rewards program. Most credit cards have a rewards program linked to them where you can earn money back for spending at certain places or using your card a certain way, thereby actually making a return on your debt. 

• Student loans. This is a controversial one as I do believe in and encourage investing in yourself. Make sure to pay your student loans off as soon as you have qualified and as quickly as possible otherwise you could do serious damage to your credit score and thereby your ability to qualify for other forms of debt – good or bad.

• Mortgage or bond on primary residence. In general, a mortgage is regarded as a good debt but if you don’t plan to sell your house once it has appreciated in value or to rent it out at a later stage then this is actually a bad debt as you keep putting money in, but get no money out. If you refinance your property and use the additional money to invest in something that gives you a monthly return that is higher than your increased bond, then you are using this form of debt to maximise your returns.

I trust that this article has been informative and will make you think twice about what kinds of debt you would like to make use of.