When you were growing up you might have been told that debt is a bad thing, but there’s certainly more to the story than first meets the eye. Understanding the difference between good debt and bad debt could help you make better financial decisions in the long-term. Learn what sets the two types of debt apart and how you can make good debt work for you.
What is good debt?
Good debt is generally considered to be a type of debt that assists you in building your wealth or increasing your income over time. It’s the kind of debt that should be thought of as an investment in your future and may take some time to have a positive impact on your finances.
Examples of good debt
Some common examples of good debt include student loans, business or investment loans, and, in some cases, mortgages.
Student loans, such as the HECS-HELP loans taken out by Australian university students, are often thought of as an investment in your future, potentially allowing you to earn more as a result of the qualifications you gain. In Australia, HECS-HELP loans are only repaid once you reach a certain income threshold, with no interest applied throughout the life of the loan. The government does index the amount owing by the equivalent rise in the consumer price index each year.
There’s an old saying that it takes money to make money and this is often the case when it comes to growing a business or making an investment of any kind. Whether you’re looking to expand your own business ventures or your investment portfolio, an initial investment is required in order for you to eventually start reaping the rewards.
Mortgages can sometimes be considered to be a good debt, especially if you are able to build equity and sell your home fora profit in the future. It’s important to remember, however, that the property market does fluctuate and you should only borrow as much money as you can realistically afford to repay. Over stretching yourself financially could have negative consequences if you fail to make your repayments on time.
As with any type of debt, good debt does need to be paid off over time. Before you commit to any form of debt, be sure to assess whether you have good grounds to go into debt and if you can realistically meet all the required repayments.
What is bad debt?
Put simply, bad debt is any kind of debt that will end up costing you money in the long run. Bad debts may have high interest rates, be used to fund assets that depreciate in value or have slim to no prospects of returning you any income.
Examples of bad debt
There are many different types of bad debt.Some examples include credit card debt, payday loans and car loans.
Often attracting high interest rates and fees, credit cards are typically considered to be one of the worst types of debt. Although they may allow you to purchase goods in the short term, they generally don’t have any long term benefits for your finances. It can be easy to fall further into debt with bad spending habits, while high interest rates see you paying more over time.
Typically targeted towards financially vulnerable people, payday loans attract very high interest rates which can make them difficult to pay off. Even if you were to pay off your loan quickly, you’d still be losing out from the high rates of interest charged and associated fees.
Although a new car may seem like a sound investment, they tend to quickly depreciate in value, with resale values typically much lower than the price you initially paid. Car loans can also attract quite high interest rates, which sees you lose out further. Despite car loans being a necessity for many in order to afford a new vehicle, it can be a good idea to buy a used car or a cheaper model to help reduce your bad debt.
Good debt vs bad debt
The main thing that sets good debt and bad debt apart is the way that they can affect your finances. Good debt may help you get on the front foot financially, while bad debt will often disadvantage you more as time goes on. Bad debt may seem like a good solution to short term financial problems, but will generally see you paying back more than you initially borrowed thanks to high interest rates and other associated fees. On the other hand, with some careful consideration, good debts, such as student loans, investment loans and business loans, can set you up for a more financially stable future, providing you with the tools required to grow your business, land a better paying job or increase your personal wealth.
How can you make your good debt work for you?
With some careful planning, good debt can help you to get into a better position financially. There are several ways that you may choose to make your good debt work for you, including:
As you pay off your home loan, you start to build equity that you may be able to redraw and reinvest in an investment property or shares.
Instead of having to make multiple repayments each month, consolidating your debts will see you pay just one, potentially reducing the total amount spent on interest too. If you are in the position to do so, increasing your mortgage to consolidate and pay off your debt could be another option.