Knowing the difference between good debt and bad debt. What to analyse and evaluate?

Debt is a controversial topic – some encourage it for bigger financial goals, while others steer clear. Unfortunately, there is no right answer to this personal finance topic, and it really depends on the individual's financial situation. Debt can be used for asset ownership, to achieve a valuable goal, and can be used as a means to multiply income.

What we are going to analyse and evaluate is whether your debt is helping you grow your financial value or harming it by looking at all the end goals and what you need to watch out for to avoid falling into pitfalls:

• What is the difference between good debt and bad debt?
• Examples of good debt and bad debt
• How to focus on good debt and avoid bad debt.

What is the difference between good debt and bad debt?

People see debt in two ways: – good debt and bad debt[1]. Good debt is seen as a tool that facilitates wealth growth, despite owing money to institutions, usually a bank. They help build credit scores, aid ownership of large assets through low-interest rates, and generally appreciate the asset’s value. Bad debt does the opposite. It usually has high interest attached to it and is mostly issued on assets that depreciate and do little to nothing to improve financial wellbeing.

However, this is just a simplification, and the difference is a little more nuanced than this. We will explore what sets good debt apart from bad debt and evaluate the pros and cons of each.

We will also analyse the nuances of the categories and what you should be looking out for good and bad debt.

What is good debt?

If we are to define good debt in simple terms – it is the investment in acquiring debt meant to secure a healthy financial future. It is often necessary to take debt to achieve goals expected in society or to increase income. Such debts are meant for the long-term, and it aims to help you acquire a high net worth asset that appreciates in value. Most good debts are of low interest that reduces the burden of payment costs. They also help you build up a credit score and often benefit you with tax returns. While often necessary, sometimes, even good debts can end up bad and lead to financial disasters (e.g. the 2008 financial crisis and the real-estate bubble[2]). Utilising debt successfully to your advantage depends on a variety of factors which we will discuss later.

What is bad debt?

Any debt that you cannot afford to take is bad debt. Bad debt does the opposite of good debt – sabotaging your financial growth. It eats away value from your net worth and negatively affects your credit score. The payment made to bad debt does not contribute to your wealth growth and instead the value of the payment decreases every time because of the nature of the debt. Usually, bad debts are on depreciating assets, have high interest rates, and are often predatory. While it is impossible to avoid them, it is important that you are aware of them so that you can, at least, reduce the impact of the bad debt.

Examples of good debt and bad debt

The following describe some common good debt and bad debt examples.

Examples of good debt

Some of the basic types of good debt are:

• Mortgage
• Student loan
• Business loan

The list is not limited to the above three, but these are generally the well-known purposes to borrow money.

Mortgage

Out of all the list of good debts, the mortgage[3] remains the most popular tool due to its historical stability. Mortgage comes with a number of benefits and is generally safer than most good debt examples. It gives access to the middle-class population to own homes at a lower interest rate and builds home equity.

However, mortgages can become bad debt if you do not understand the home market. For instance, during the 2008 financial crisis[4], the housing market crashed to the point of people leaving their homes, allowing banks to foreclose. Mortgages became unaffordable for owners to pay. Although the crucial reason was the subprime mortgage, buyers had little idea about their ability to borrow and pay and took out loans they could not even afford to pay back. Most buyers did not know the basics of taking out a home loan, especially the adjustable rates, which increase the monthly payment as the price of houses drop. Such a lack of financial understanding turned an essential debt into bad debt.

So, what should you know about mortgages before taking out one? Here are some of the things you should factor in before considering taking out a home loan:

• Can you afford it? It entails not only the ability to pay monthly but also your circumstances, such as how big is your family, are you the sole earner in your family, do you have financial support from other family members in the event of losing your income, etc
• Ideally, mortgage payment, including insurance, should not exceed 28% of your monthly income[5]. While there are other factors, like loan terms, you should look at the adjustable rates and the likelihood of it increasing over time should the value of the house decrease

The list is not exhaustive, but these are the primary concerns that need to be understood. And although no one likes being in debt, a mortgage is the only way for many to home ownership, so such debt is justifiable if taken responsibly.

Student loan

Although student loan has received negative publicity because of the rising levels of debt and the pandemic, for the purpose of this article, we will only discuss the primary role of student debt and what you need to consider before taking on such a large responsibility.

Like homeownership, student debt is meant to give an individual access to education with low interest rates, who otherwise could not have afforded it. Since education has positive correlations with better earning potential and finding good employment, many take this debt as a necessary investment to better their financial future. It is good debt because the degree is more likely to provide them with opportunities than without.

It also helps build your credit score, if you pay on time. The ideal borrowing number should be limited to 1.5 times the amount you expect to be your first-year salary[6]. It becomes a bad debt when the economy cannot provide the graduates with the opportunity that the degree was meant to provide. To avoid it being a bad debt, you must consider evaluating some essential questions:

• The degree: not all degrees and subjects carry equal job market value. Before deciding to take out the loan, ask yourself what kind of degree it is – is it a higher education degree, a diploma, or a graduate pathway, etc. Does it have a demand in the job market? Examples could be a master's degree in STEM, Law, or business/finance
• Monthly payments schedule – are the interest payments suitable? Can you afford to pay? Can you take a grace period or negotiate rates etc?
• Do you have other methods of financial support? This not only entails scholarships and bursaries but also family members who can provide financial support in case something goes wrong

Student debt, ultimately, is a financial burden, despite its good reasons. However, understanding your circumstances is the key method to evaluate whether student debt is good for you. Research has shown that higher education is more likely to pay off in the long-term[7]. The disadvantages of student debt can be solved if the state authorities took initiatives to fill the gap between graduates and the job market by providing temporary programs to help graduates adjust.

Business loan

Creating and running a business successfully is notoriously difficult but also financially rewarding if done right. You need a lot of cost capital to start a business, which many will undoubtedly not have. You need debt to jumpstart the first few years of your business. Business debt can be for anything that is needed to run the business as opposed to a personal loan – it could be auto loans for the purposes of using it in the business operations, credit cards for running the business, debt to buy equipment for the office and etc. The debt could be for anything as long as it is for the business operations.

It could be good debt, depending on your business understanding and skills, because businesses are expected to grow in value and generate income in the long run. Business debts also come with a number of benefits, such as:

• Limited liability from the business
• Support from the State in the form of lower interest rates, debt reduction, or forgiveness
• Cheaper and less risky in the long run than equity financing, because you do not have to pay shareholders/investors

But it also carries significant risks. New businesses are more likely to fail in the current conditions and it is more difficult to get loans from traditional institutions like banks. Hence careful business planning is essential to ensure that you do not default on your loans. It includes consulting with a financial professional regarding pooling capital, payment schedules, and running the financial operations of the business in general.

Anyone taking out loans for creating a business needs to realise few key things, such as:

• Do you have a business plan?
• Do you have the necessary capital?
• Do you have a solid customer/client base?
• Do you have the necessary emergency funds for the business should you lose your client base?

And many more! Obviously, there are more questions to be looked at, depending on the financial situation. It also depends on how much financial aid is available to support the small business. Ultimately, business loans are nothing like personal loans and their consequences will be very different. You need to look at all the possible dies before taking that much debt.

Examples of bad debt

Some best-known types of bad debt are:

• Depreciating assets
• High cost of debt

Depreciating assets

Depreciating assets[8] lose their value over time with use. Automobiles are a prime example and are considered bad debt. While you cannot live without a car in many countries, buying it without debt is an impossible task for many. Going into debt for an asset that loses value, is not a financially smart choice but it is a necessity that many have to undertake. Nevertheless, borrowing money for depreciating assets need not be bad debt if you take some precautions, such as:

• Try to look for borrowing options that have little to no interest on payback
• Try to pay as much as you can upfront to lower your interest rates
• If there is room to negotiate prices and interest rates – do it!
• If you can afford to buy the asset in cash, then better to buy it in cash

Owning a depreciating asset should not be daunting to individuals who really need it. You just need to understand your financial circumstances before going into debt for an asset that will low value over time. Once you do, you will have the confidence to negotiate better terms and may be able to pay it off without affecting your finances.

High cost of debt

All bad debts come with high interest rates. While some car loans and payday loans have high interests, the most well-known example of high-interest bad debt is a credit card. The interest rate of a credit card can be as high as 30%[9] and is known to be the worst kind of consumer debt. They are difficult to pay back and many default on their credit card payments due to time constraints and no leeway. Credit card defaults will result in your account being closed and reported to the credit bureaus which will negatively impact your credit score. This will also impact your opportunities of taking future debts which could be good for your financial health (e.g. mortgage).

So, how to avoid credit card debt? While you cannot avoid using credit cards altogether, you can take some steps to reduce their usage or use it wisely. Some good steps could be:

• Make a budget
• Use credit cards for emergencies only
• Pay your bill on time
• Do not take too many credit cards

Like all debts, credit cards need not be the bad guy. You can benefit from credit cards, through their reward systems, discounts on services, and many more which will make your purchases worthwhile and at the same time, increase your credit scores too. You only need to be responsible with them.

How to focus on good debt and avoid bad debt

The way you spend your money has an impact on whether or not you have good or bad debt. It's crucial to remember that any debt that's too high or that's used to buy wants rather than necessities should be avoided. It takes work and a mindset shift to develop the habit of taking on good debt and avoiding bad debt. Good debt is earned by making intelligent financial decisions, not just for the sake of having good debt. You might, for example, elect to get a mortgage to boost your equity growth. If you don't have any other options for financing your home, getting a mortgage could be a good reason to take on more debt.

Also, be prudent in your debt repayment method. It's always a good idea to prioritise paying off your bad debts first, as they will likely cost you more in fees and interest than your good obligations and have less cost. Prior to handling mortgages or student loans, you should pay off credit cards and auto loans. Some people think about using good debt to pay off bad debt, such as taking a lower-interest loan to pay off a higher-interest loan.

Furthermore, just because you have a good debt rather than a bad debt does not mean you should borrow all of the money available to you.

When deciding to borrow money, use your best judgement. If you wind up becoming house poor[10] as a result of your home purchase, you may regret it. Maintain a debt-to-income ratio of less than 35%[11] of your gross revenue.

And if you're thinking about taking on extra debt to acquire something, be sure it's for the right reasons. Ask the following questions to yourself:

• Will I be able to show that this money was well spent in the next year or five years?
• Do I need the money right away? Is it possible for me to save up for it instead?
• Is there any other option for paying for this?

Even if the debt is considered good, you should make every effort to pay it off as soon as feasible. It will enable you to start accumulating wealth. It can also assist you in pursuing your goals because you will be less reliant on your monthly wage.

There are numerous reasons to eliminate debt. If you're serious about getting out of debt, you'll need to create a budget and a debt payment plan that allows you to make additional monthly payments to your loans. If you handle your money properly, you can pay off your debt faster than you think. It may include taking on a second job for a limited time or reducing your lifestyle, but the sacrifices will be well worth it.

Summary

Debts are an inevitable part of life in the current economy. Without debt, one will not be able to progress financially. Debts can be good or bad, depending on how they impact you in the long run. Good debts usually improve your credit score, which allows you to take on more financial aid from institutions. Bad debts do the opposite. Some good examples of good debt are mortgages, student loans, or business loans. Common examples of bad debt are usually car loans or credit cards. But the examples are not solidified in their categories. Good debts can become bad debts if you are unable to benefit from them in the long run. Therefore, you have to evaluate the impact of debt before you take it on your shoulders. You can make a budget and pay the loans off as soon as possible.

Not all debt can be classified as good or bad so easily. Often it depends on your own financial situation or other factors. Certain types of debt may be good for some people but bad for others. Some bad debts are necessary due to their circumstances. We do not advise anything – we do not advise that you take on debt mentioned in this article. However, we do, recommend that you evaluate your financial situation before taking on any debt and use these tools wisely to your advantage.

List of References

1. Source: investopedia.com
2. Source: investopedia.com
3. Source: investopedia.com
4. Source: investopedia.com
5. Source: chase.com
6. Source: forbes.com
7. Source: forbes.com
8. Source: investopedia.com
9. Source: cnbc.com
10. Source: thebalancemoney.com
11. Source: thebalancemoney.com