We are all aware of the word debt and most of us have probably experienced it at some stage of our lives.
But what is debt? Debt is simply borrowing money from another party to buy goods or services that you cannot currently afford. In today’s world where credit is offered to us in many forms, most people generally like to buy on credit rather than wait until they have saved the money. The general perception is that debt is bad; but debt can have positive or negative consequences depending on the outcome and what it is used for. Hence it is important to understand the difference between good debt and bad debt to ensure that your money is put to best use.
What is good debt?
Good debt is any sensible investment that will leave you financially better off in the future. It is important to have a clear and specific reason about why you are taking on the debt and a realistic plan of the time frame and how you will pay it off. This also means that you have done your research on all the charges involved in taking up the debt and implications on other areas of your life. For example, you might have good earning potential and want to build an investment property portfolio as a means to retirement through investment loans.
Other examples include investing in your business, buying shares or a new car.
What is bad debt?
Debt that is used to fund your lifestyle, purchase something that will significantly decrease in value, entails interest which is not tax deductible or doesn’t produce any income is called bad debt. Examples include credit cards, store cards or personal loans to go on a holiday or to buy an expensive car. Debt has become such a part of life that generally most of us use credit cards without a second thought, not realising that it is actually bad. The general rule to bad debt is that if you can’t afford it, don’t buy it.
Tips to avoid bad debt
When borrowing money ask yourself the following questions. If the answer is ‘no’ then you probably shouldn’t be taking on that debt.
- Will borrowing money improve my finances in the long run?
- Have I shopped around to find the best deal possible?
- Will I be able to make repayments if the interest rate goes up? E.g. using a credit card to make purchases that you don’t need – a handbag or a pair of shoes.
- Do I understand all the terms and conditions (the fine print) associated with borrowing this money?
- Do I know my plan B if there is a situation where I can’t make repayments anymore?
Can bad debt ever be good?
Buying on credit is a good thing if you are the kind to make regular payments when needed.
Consider this example. You have a home loan and you use your credit card to pay for your living expenses, but pay off the debt in full at the end of each month. This way you have used the card as a cash flow mechanism which helps you leave your salary for a longer period in your offset account, saving dollars on your repayments.
Debt on a credit card becomes bad debt if you use it to make purchases and roll the balance over from month to month, with interest being added to the balance.
Putting it all into practice
When you have made some bad debt decisions and want to get out of it, the first step is to write down the plan of action on how you will get rid of the debts. The general rule of thumb is to pay off your high interest bad debts first, such as credit card debts– either pay them off quickly or roll over into a low interest rate credit card and make more than the required payments. The next to be paid out should be car loans and personal loans.
In many cases people consider increasing their home loan (good debt) to pay off their personal loans or credit cards. Although this is a good idea in theory, it can become a habit which may spiral out of control where you end up paying too much for your home loan by consistently extending the term of the loan and not making extra repayments.
Tackling debt effectively requires you to have a basic understanding of your short, medium and long term personal goals and working out whether any debt will actually help you achieve those goals or not. This is what rich people do – they only take on good debt and avoid the bad debts. By following these steps and understanding good from bad when it comes to debt you will be on your way to becoming rich.