Very often people will assume that all debt is ‘bad’. Sometimes owing money or obtaining any form of credit is considered indicative of poor money management skills. However, this is simply not true. Debt and credit can serve very useful and positive functions. Used correctly and with care, the use of credit and even debt can be ‘good’.
Good debt is a planned and budgeted for investment in your financial future. Sometimes having a small debt now can prevent a much larger expenditure later. Good credit can be used to purchase assets that can depreciate only very slowly or in some instances grow to be worth more in time.
Mortgage – Investing in bricks and mortar has long been the long-term investment of choice for many. For most people, they can look forward to their home increasing in value over the course of several years. Of course, short-term fluctuations in the housing market might see your home drop in price temporarily, but over the longer-term you are likely to make a profit. In addition, mortgage interest rates tend to be lower than many other types of credit.
Car or other vehicle loan – An affordable car (or other vehicle) purchased with credit is a good example of an asset that provides a good, long-term return for your debt. Of course, cars, vans and other vehicles do typically go down in value over time, so the benefit is not in its resale value, but rather in the practical benefits of having a reliable means of transport – especially if this is required for work or your own business.
However, there comes a point where a car loan can become a ‘bad’ debt – for example, spending a lot more to purchase a new or luxury vehicle where an affordable alternative will do just as well. Buying a brand-new Rolls Royce for a commute trip to your workplace of just 10 min is a rather extreme but illustrative example.
Student loan – This is a good form of debt where you are investing in your own future employment prospects. For many, a University degree or college education enables them to reap the rewards of a higher-paying job with better career prospects. Of course, this does mean starting out your career with large debt, but this is offset by the low interest rates and the fact that you will not be required to repay this until you are earning a certain amount.
Credit building debt – It’s an unfortunate truth that in order to get a good credit score (or repair a bad one) you must first get credit in some form. Younger people who are looking to access credit for the first time will find that they are considered a ‘bad’ risk. This is not because they have demonstrated poor money management skills, but rather the lender has nothing to base their assessment on as to how they will deal with credit.
For these people (and those rebuilding a credit history), having debt that you are actively repaying, on time and with no problems, is a good thing and works to improve their financial standing.
Business loans – In the case of business, loans that help the business grow and prosper are a positive use of credit. This is especially true if the business succeeds and become much more valuable as a result.
Bad debt adds little or nothing at all to your overall assets or prospects. This is the money paid for items that decrease in value quickly or may have no value at all after the initial purchase.
Credit card debts – Unless you are wisely using a 0% interest purchase credit card, items that are bought using a credit card come with relatively high interest rates. If you don’t pay off the whole amount every month, the money owed in interest can quickly outstrip the value of the asset purchased.
This becomes even worse if you are using a credit card for purchasing things like restaurant meals or holidays. These are things that leave you with no discernible assets (beyond sheer enjoyment) and consequently can be seen as ‘bad’.
Payday loans – It’s hard to imagine a form of credit that makes you pay so much for so little. These short-term loans are intended for small amounts taken out over less than 30 days. With interest rates that can be around 1000% p.a., these can quickly escalate to be a highly expensive way of using credit.
Borrowing money to service other debts – Using credit to service the repayments on another debt is an excellent example of ‘bad’ debt. For example, using a cash advance from one credit card to pay off the minimum amount on another does nothing to resolve the original debt and will result in high interest rates and even more fees to be paid on the cash advance.
Where possible, avoid using credit to pay for assets that depreciate in value very quickly (such as clothes, meals out and luxury holidays) and when you cannot repay the total borrowed in less than a month.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.