Contrary to popular belief, not all debt is bad. Like all things in life, debt too comes in pairs, with some being good and some bad. From payday loans and personal loans to credit cards and student loans, debt can take various forms.
But how do you know which debt is good and which is bad?
Good debt is generally the debt that helps you build wealth or better your financial position. Bad debt is generated when you’re liable to pay someone for something you really cannot afford and doesn’t offer you any long-term benefits.
But it’s not as simple as it sounds, as debt can often be misleading if you’re uninformed. Misunderstood financial debt can lead to a complicated love-hate relationship or a debt cycle that ends up doing you more harm than good. You need to understand debt and the difference between good and bad debts to make better financial choices.
So how do you go about managing debt? How can you get the most out of good debt without being driven into the unending vortex of bad debt?
Short answer – there’s no secret formula. It takes a series of steps and financial discipline to make sure you tread the debt minefield carefully.
This article explores good and bad debt in greater detail and how to ‘break up’ with the debt cycle.
What Is Good Debt?
Good debt is akin to a form of financial instrument that can help you reach your financial goals and has the potential to increase your net worth. Good debt is seen as an investment, especially for businesses or individuals looking to grow in the future.
Under ideal circumstances, the following are some of the common examples of good debt investments:
Personal Loans
A personal loan can be helpful to combine your debts at a lower rate of interest. Moreover, securing an unsecured personal loan does not need any collateral like a property.
Mortgage
Purchasing a house is a huge decision that also requires a lot of investment. Without a debt instrument like a mortgage, most people would’ve found it difficult to buy a house as it’s extremely expensive to afford. Taking a mortgage on your own or jointly with other people essentially means a loan where your property is the collateral for securing the loan amount. Mortgage payment means building your equity, leading to a higher net worth.
Student Loans
With the cost of education in the UK on the rise, a student loan can help pay college tuition. This loan is a good debt as it invests in your future. Getting a degree after college improves your prospects for earning better.
Business Loans
Starting a business is usually seen as an opportunity to build wealth. It’s a good idea to take a small-business loan after you’ve carefully weighed the pros and cons of your business start-up idea.
Good debts can also help you build a good credit score, however, bear in mind that these debt options remain ‘good’ for you only if you stick to the repayment schedule and prevent it from negatively affecting your credit scores.
What Is Bad Debt?
Some types of debt can be worse than others, especially when it’s increasingly difficult to repay or arrives without any benefits. Such debts are known as bad debts. Often bad debts come with higher interest rates than usual or/and with unsuitable terms of loan repayment.
Bad debts often appear in the form of:
Unaffordable Debt
Debt can be classified as bad debt if it is almost impossible to repay on time. For instance, unpaid credit card bills that keep piling up over months of non-payment can turn into bad debt. Coupled with higher rates of interest, you’re often left with no option but to borrow more to pay off. Quickly disbursed short-term loans that have high interest rates are also a form of bad debt.
Debt That Negatively Impacts Credit Scores
Another sure-fire example of bad debt is one that impacts your credit scores negatively. Unpaid mortgage loans or falling behind on monthly payments can affect your credit scores.
How Do You Break Up with the Debt Cycle?
Most people don’t realise how they’ve slipped into the slippery slope of the debt spiral, also known as the debt cycle. Even good debt can turn bad if it’s poorly managed. What you end up with is a mountain of debt that keeps growing with time.
The first and foremost step to breaking a debt cycle is to stop borrowing money. The next is to figure out your income and expenses through a tracker. Drawing up a budget can help you track how much money you owe, to whom and how soon you can pay it off.
Once you’ve got your finances in order, design a stringent repayment strategy with a step-by-step process. You have several options for paying off your debt, including working with a professional.
Do not go back to your old ways after you have paid off all of your debt, but also do not let debt scare you. Before you take on another loan or mortgage, consider your debt-to-income ratio (DTI). DTI helps in understanding whether or not your monthly income can afford the debt you’re about to take. If the calculated DTI is high, you should reconsider taking on the debt.
In Conclusion
Debt is a double-edged sword; whether it’s good or bad for you depends on how well you manage it. When used right, it can improve your financial standing in life and improve your prospects. You might want to steer clear of debt altogether, but it can often result in a missed opportunity of striking when the iron is hot. When used poorly, debt pushes you into a spiral that’s incredibly difficult to get out of.
How you see this love-hate relationship of debt depends only on you and your choices.
