Bad Debt vs Good Debt

Tuesday, June 6th, 2017

The definition of debt is the process of one party borrowing money from another party.

These days, for most of us, having some type of debt is simply a part of life. But not all debt is healthy – and too much can get us into financial stress and difficulty.

To help you understand how to manage your debt effectively, it’s important to understand the difference between good debt and bad debt.

What is Good Debt?

Generally speaking, good debt is debt that helps you increase your net worth over time.

Good debt enables you to manage your finance and leverage your wealth. Good debt is used to buy things you need.

Some examples of good debt include:

Mortgage (especially a mortgage that has a degree of tax deductibility associated with it)

Buying things that save you time and money

Buying essential items

Investing in your education

Today’s house prices mean that very few of us will ever be able to afford to buy a property using only cash savings.

Borrowing to finance a home, through a mortgage, allows you to pay back a home loan over a set period of time. Hopefully, if the house increases in value over that time period, you can make a profit if you eventually sell it.

In addition, the interest that you repay to your financial institution for an investment property may be tax-deductible – letting you minimise your tax obligations at the same time you are paying interest for the privilege of accessing this money.

Borrowing money to invest in this way can be considered good debt.

Investing to Build Your Future Earnings

Statistics show that, generally speaking, the higher education a person has, the more ability they have to earn a higher income.

Of course, higher education is not a guarantee of financial success but taking out a student loan to pay for tertiary education that can lead to you achieving a high-paying job in the future can also be considered good debt.

Borrowing for Business

You might have a great idea for a new business but that alone is not enough to guarantee your entrepreneurial success.

Securing seed capital or taking out a small business loan is often a necessity to help build and sustain a commercial enterprise. In this way, borrowing money with a view to building wealth is another example of good debt.

There are also times you need to borrow additional monies to help meet the cash flow requirements of an established, but growing business.

What is Bad Debt?

Unlike good debt, bad debt does not increase wealth and is typically used to buy goods or services that don’t have any lasting value.

If you are using credit card debt to buy luxury items you don’t really need or just to meet your daily living expenses, you can find yourself in crippling debt – paying back over-inflated interest on items that do not help you build wealth.

Bad debt is usually considered to be any form of debt that carries a high interest rate. Bad debt gets worse with poor management, when people fail to repay minimum payments and interest keeps compounding and escalating.

Borrowing money from any lenders which has a negative impact on your credit rating is considered bad debt.

 

The Impact of Bad Debt

Even good debt can have a negative impact if:

mortgage

jeopardy

ability to repay it may be lessened through reduced income

While some people consider the purchase of essential items – such as a car – is good debt, it’s only true with the right finance terms. Cars depreciate in value and each month you own yours, its value decreases.

Financing a new car for 48 months (four years), without putting much or any money down could be viewed negatively by other lenders who would normally evaluate you as a good prospect for future loans.

The main difference between good debt and bad debt is the overall value of the debt – and understanding which costs you less in the long run.

 

For a better understanding of good debt vs bad debt and how you can minimise the bad debt in your life, talk to an experienced finance broker or lending specialist.

 

If you have any questions about your finances, either personal or business, please do not hesitate to contact Loans Actually on (03) 8805-1850 or email glenn@loansactually.com.au


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