Did you know that debt can be both good and bad?

While the idea of debt ever being considered ‘good’ may seem strange, it is important to know that there is a difference between the types of debt you incur.

The most important aspect you need to consider when taking out a loan or buying on credit, is whether the debt you’ve incurred is good or bad debt. Also keep in mind, that the classification of the debt will be dependent on your financial situation. So, what is good debt and what is bad debt?

Good Debt

Good debt is an investment that will grow in value or generate long-term income. Examples of good debt would be taking out a student loan to pay for an education; real estate, including taking out a mortgage loan to buy a house; even small business ownership can be considered as good debt because making money is one of the many reasons to open a business. While these examples can be used successfully to build wealth or increase your income, this won’t always be the case. The successful use of good debt depends on a number of factors.

According to financial advisors, the rule of thumb when taking out a loan is that you shouldn’t borrow more than you expect to make in your first year working. For example, if you are doing your master’s degree, the amount you expect to start earning once you get a job, shouldn’t be less than the loan you take out to fund your education. This ‘rule’ takes into consideration the fact that your salary should increase yearly which then accommodates for the interest you’ll accumulate on your debt.

When it comes to your mortgage loan, a good rule of thumb to have is that the loan should always be less than 28% of your gross monthly income. You should also consider the terms of your loan. It would be ideal to find a mortgage payment level that works for you in the long term while factoring in any potential event(s) that could affect your income in the future. Also keep in mind the good debt-to-income (DTI) ratio, which is based on the fact that your DTI should never be more than 36%. To work out your debt-to-income ratio, add up all your monthly debt payments and divide them by your monthly gross income.

The biggest determinant you should think of when accruing debt is, will this debt pay you back more than what you are putting in? There is a lot of thought that needs to go into this, but this thought process will help you determine whether the debt you want to take on will be more of a burden to you than beneficial.

Just remember, know what the debt will do for you, and it should always do more for you than what you do for it.

Bad Debt

In comparison to good debt which has the potential to increase your net worth, bad debt is any sort of debt that is borrowed for depreciating assets. In simple terms, if it won’t go up in value or bring in income, it is advisable not to go into debt to buy it. Bad debt is also any debt that carries a high interest rate, such as a credit card. Always remember with bad debt, if you can’t afford it and don’t need it, then don’t buy it.

Some examples of bad debt would be a car, because new cars in particular cost a lot of money. While the car might add value to your life because it’s saving you money on public transport, the value of the car is constantly decreasing from the moment you leave the dealership which means that you will never make your money back on the car. Paying back the interest on your car will also mean that you will end up spending more on it than you would ever get back.

Another example is credit cards, these are one of the worst forms of bad debt. The interest rate that is charged is much higher than other loans and most times than not, the payment schedule for the credit card is arranged in such a way that it maximizes the costs for the consumer.

A payday loan or a cash advance loan are also forms of bad debt which are advisable to avoid. A payday loan involves a consumer borrowing money which he has until his next payday to pay back, but interest is now included in the amount needed to pay back.

If bad debt is something you have incurred and you’re struggling to handle it, please don’t hesitate to let us help you get a handle on your debt. We will walk this journey with you.

Key points:

– Good debt is a loan that has the potential to increase your net worth

– Bad debt involves borrowing money to purchase depreciating assets

– Determining whether or not a debt is good or bad sometimes depends on an individual’s financial situation, as well as other factors