Raise your hand if you think ‘debt’ is always a bad thing.
If your hand is up, you won’t be alone because for many of us, debt is something we associate with fear, panic and, let’s face it, being a bit hard up.
However, the truth is that not all debt is bad and knowing the difference between good debt and bad debt can help when applying for credit and being smarter with your money.
What’s good debt
Good debt is any affordable debt you get into that could be seen as a sensible investment for your future and well-being. In other words if it will make you better off in the future and you can afford to pay back the loan each month, chances are it’s actually good debt.
Examples of good debt:
- Mortgage: Property is one of the best investments most people make and usually a home will appreciate in value
- Student loan: Taking out a loan to pay for higher education is not only common, but an investment in your future. A student loan also offers some of the lowest interest rates.
- Starting your own business: Usually you will earn more from the business then what you put in. However, it does always depend on trade and the type of business you have.
- Credit cards or loans: Credit cards and loans can help you create a credit history, which is important if you want to apply for a mortgage, buy a mobile phone or even get a new job. If you can afford to take out a credit card or loan, you make smart purchases using them, and if you can build up rewards, they can be a good financial choice.
- A new car you can afford: When public transport isn’t available where you live or is very limited, you may need to purchase a car so long as you can afford it. Sometimes it can be cheaper to buy and maintain a car compared to the amount you may spend on taxis or trains and/or saving you time.
- Investing: This works on the principle that ‘you have to spend money to make money’. If you go into debt to fund a project that will give you high returns or to buy something that will appreciate in value, people will often consider this to be good debt.
What’s bad debt?
Most people consider bad debt to be anything you can’t actually afford to repay and/or won’t ‘pay for itself’ further down the line. There are also some that consider debt to be bad when it’s used to pay for something that will depreciate in value, such as a new car. Nevertheless, as long as you can pay off the debt by meeting monthly repayments, it’s generally not thought to be a bad thing.
Examples of bad debt:
- Clothes and consumables: These depreciate in value and have a short life-span so are unlikely to pay for themselves. Consequently, borrowing to fund them isn’t usually thought to be a smart move.
- Borrowing from payday lenders: Interest rates on payday loans can be much higher than those offered by other forms of lending, putting even more stress on you when it comes to making repayments.
- Anything you can’t afford: The rule of thumb is that if you can’t afford to get out of it, don’t get into it. Be sure you can afford any repayments and don’t borrow more than you can reasonably pay back.
Avoiding bad debt
Staying away from bad debt comes down to making smart choices. Your credit score and report – which, alongside other factors, influence a lender’s decision to approve you for credit – can be a great indicator of whether or not you’re in a position to take on more debt, as well as helping you monitor the debt you have. If you’re credit score is high, you could be in a good position to borrow and meet repayments. If it’s low, consider taking steps to improve it before taking on certain types of debt, such as a mortgage or car finance.