For many people, debt has become the norm. Debt can be used to make small every day purchases such as milk to large one in a lifetime purchases such as a family home. There are those that consider all debt to be bad and should be paid off as soon as possible. However not all debt is equal.
It is possible for some individuals to live completely debt free, but this is unlikely to be the most efficient use of your money. Before deciding whether or not to buy on credit or to repay the debt sooner rather than later, it is important to first establish whether the debt is considered to be good debt or bad debt. Ask yourself, is the purchase worth going into debt for?
What is good debt?
Good debt is one that is used for an investment that will create value and leave you better off in the long term. Whether this is by increasing your income or allowing you to manage your finances more effectively. Don’t forget you need a realistic plan for paying it back, even if it considered good debt.
Examples of good debt:
Taking out a mortgage to purchase a home. It can be daunting to think of yourself as being in hundreds of thousands of pounds worth of debt, however this is considered good debt. Residential mortgages have low interest rates compared to other debt, therefore the relatively low interest rates allow you to use your savings for other investments such as stocks and shares. Mortgages are a long term debt (mostly in the region of 20-35 years) and stocks and shares are a long term investment, over the long term you will have earned more money on your investments than you would have saved if repaying the mortgage early. You can also take out a mortgage to purchase a buy to let property, generating a passive income stream. Ideally, the value of your property will also increase over time, potentially enough to cancel out the interest paid over the term of your mortgage.
Although cars depreciate in value over time, they can be considered good debt if a car allows you to earn a higher income and further your career by travelling greater distance for work or for business. However they do have a higher interest rate and are for a shorter term, it is usually best to repay them sooner rather than later. Don’t get me wrong, I’m not encouraging you to take out a large loan on a fancy car (this can be considered bad debt), it is important to be conservative over how much you are paying for a car and ensure you can support the monthly payments as well as maintenance expenses.
Student loans are becoming increasingly expensive however they do still have a lower interest rate than other types of debt. Obtaining a university degree increases value as an employee and can advance your career greatly thus increasing your potential future earnings. Plus you don’t pay them back unless you are earning above a certain level.
A business loan can be considered good debt as it can increase the value and income, but only if used in certain circumstances. If your business is doing well you may want to take out a business loan to invest further. For example, if you sell a product and have a large order to fulfil, you may need to take out a loan to produce a higher quantity with the knowledge you will make a profit. You may want to hire more employees if you have a high demand for your services that you cannot meet. You need to ensure you have a viable business plan to be able to pay back the business loan. It would be considered bad debt if the business is underperforming or you are trying to save your business and make ends meet.
What is bad debt?
Bad debt is debt is one that is used to purchase items that lose value quickly and do not generate a long term income. Bad debt reduces your wealth and is not usually affordable as it have a high interest rate.
Examples of bad debt:
Payday loans are the worst type of debt due to the extortionate interest rates. What makes them worse it that they are easy to take out and can even be transferred into your bank account within a matter of hours. The purpose of a payday loan is if you do not have money available for essential living expenses due to unforeseen circumstances, but you know you will be paid in a few weeks and know you will be able to repay the loan in full. Payday loans are designed for very short term borrowing. However the problem arises when you are unable to repay the loan within the a short time period, the extortionate interest rates (up to 6,000%) add up alarmingly fast.
For example, Wonga’s quoted representative APR is 1,509%. Let’s say you borrow £500 for one month, you would need to repay £630. If you are unable to pay, after three months it becomes £1,001 that is double what you originally owed and on top of this you are charged later payment fees. You can see how easy it is for the debt to spiral out of control.
Credit card debt
Credit cards are typically used to purchase items that we want rather than need, such as additional clothing, going out to eat and drink, an item of furniture etc. You may get immediate gratification from these purchases however they do not provide you with any long term value. It is so easy to pay for a purchase with a credit card rather than planning to save for it and purchase at a later date. Most people who get into credit card debt have the intention to pay it back in full, however fail to plan to repay the debt, the interest on the debt then adds up over time and can become unaffordable. Credit card debt can also spiral out of control, although not as fast as payday loans.
Unsecured personal loans
Personal loans can be taken out for all sorts of reasons, including expensive holidays, weddings, cars etc. These are not things that you need, but things that you want. If you cannot save the money to make the purchase with cash then do not do it. Either save to purchase at a later date or purchase a less expensive holiday, wedding, car etc.
To avoid bad debt, ask yourself:
- Do I really need it?
- Can I afford it?
- Can I find a cheaper alternative?