Good Debt vs Bad Debt: How To Tell The Difference& Why It Matters
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Good debt sounds like an oxymoron. Time and time again we hear that all debt is bad. Is there such a thing as good debt? When does taking on debt become a good thing?

What is good debt?

A good debt is when your debt is an investment that generates income long term, or will grow in value. A student loan to pay for a tertiary education is anexample of a good debt. Student loans are interest free if you remain in NZ, and low interest even if you leave the country. If you choose your field of study wisely, the qualification and skills you gain from your education increases your future earning potential and likelihood of being employed.

Buying into a business or creating your own company is another example of good debt. It gives you the ability to create income, and if you’re really good, make a lot of income!

Is a home loan a good debt?
Buying a family home is a perfect example of a good debt, and arguably there is no better form of debt. Your property appreciates in value. If a $500,000 home only appreciates 3% a year, in 20 years you’ll own a (hopefully freehold) home worth $903,056.

Buying a rental property is also an excellent good debt. If you calculate your return on investment and make wise choices into which home you buy, a tenant will be paying your mortgage for you and in the future you will have a debt-free asset that’s generating income for you.

What is bad debt?
Bad debt is when money is used to buy a depreciating asset or something that does not generate income. Furniture, clothing, holidays, weddings and the latest gaming console are examples of things that would be bad debt.

Some things can be good or bad debt
Buying the latest high spec car is bad debt. But buying a cheap, economical car that you require in order to take up a well-paying job is a good debt. Also, if you buy a ute or truck to enable you to conduct and carry on business, that is considered good debt. While a second hand reliable car can – in the right circumstances – be good debt, the latest Mercedes Benz is not.

Similarly, borrowing to buy technology is a good debt if you’re using it to make money. A freelancer’s new laptop or a new phone for someone who uses their phone for work are examples of good debt. It’s a bad debt if you’re using it for fun or just for your Instagram photos (unless you make money from your Insta account).

So the message here? Whether a debt is good or bad depends entirely on what you buy and the use you put it to.

Good loans vs bad loans
But that’s not the end of the story. It’s possible to have a good debt but achieved through a bad loan. So how can you tell the difference between a good loan and a bad loan?

A good loan is a 12-months-no-interest hire purchase, if you pay off the item in the allotted 12 months. A good loan is a mortgage, typically at a lower rate than almost any other form of debt. However, credit cards, payday loans, and cash advance loans can have eye-wateringly high interest rates that are often compounding, and will cost a lot in interest.

Say you purchased a new TV. It cost you $1,200 and you bought it using your Visa, at an 18.9% interest rate. If you only paid off $60 a month (the minimum), it would take 63 months to pay off and you’d pay $476.98 in interest. Ouch.

Even worse, a payday loan can be an absolute finance killer. Say you borrow that $1,200 off a payday loan lender. You have to pay it back in three months, but in those eight weeks alone, you could accrue a whopping $347.26 in interest. If you took a year to pay it back, you would pay $1,482.16 in fees and interest. Bad debt indeed!

While the interest rate you have to pay is a clear distinction between a good loan and a bad loan, repayment terms and other factors can also turn a loan bad if you’re not careful.

What’s your debt-to-income ratio?
This is another clue that your debt is sliding into financial disaster. Add up all your debt payments each month. Divide by your monthly gross income. This is your debt to income ratio. Anything higher than around 40% is something you should be worried about.

For instance:

Expense Cost per month
Mortgage $4,000
Personal loan $2,000
Credit card repayment $500
Car payment $800
TOTAL $7,300
Monthly income $10,000
Debt divided by income $7,300 / 10,000
Debt-to-income ratio 73%

 

If your debt to income ratio was really 73%, it might be time to start selling internal organs. This is bad (really bad) debt.

The grey area: Turn bad debt to good with debt restructuring
They say nothing in life is black and white. Finance is the same. Debt restructuring and consolidation loans are a fantastic idea to rid yourself of high interest debt such as credit cards or cash advance loans. If used wisely, they can be a great tool whipping your finances into shape. However, some people will find that consolidation loans make them feel better about their finances, allowing them to go and get themselves into debt again.

Credit cards often offer reward programs. If you manipulate the system, using only one credit card and using the rewards they offer (and pay the balance of the card promptly every month) then a credit card can be a great idea. Most often than not, the rewards are useless, the interest cost is worth more than any benefit gained, and the debt simply becomes bigger and difficult to manage.

What’s the take-away here?
If the debt you’re getting into is going to make you money in the long term, it’s a good debt. If the debt is only going to place stress on your finances and drain your bank account… it’s bad and you should avoid it at all costs.

Bad debt can’t be turned into good debt but it can be made more palatable with a good loan. Shop around, do some debt restructuring, get lower interest rates, pay off debt as fast as you can, and NEVER use your credit card as a finance company.