The difference between debt that can help your money grow, and indebtedness, which has the opposite effect, lies mainly in how you use the debt, and whether it can generate financial benefits.
We ask the experts how to distinguish between “good” and “bad” debt, and how to use debt wisely.
Tip: Is indebtedness preventing you from living your best life? Consider debt consolidation.
Funding assets vs liabilities
Debt can be either a tool or a crutch. “Good debt applies where the purchase will outlast the debt,” explains Paul Menge, an actuarial specialist at Momentum Investo.
“It’s used to buy assets – for example, a home, an education, or a business – that will hopefully increase in value, or generate an income in the long term.”
Bad debt, however, buys liabilities – for example, clothes, holidays, recreational vehicles, jewellery, or branded goods – creating financial obligations that last longer than the purchase.
“Any unaffordable debt is also bad debt,” notes Menge. "This applies where the ratio of debt to income is high – that is, more than 20% of your income."
Erin White, a director at Crue Invest, says debt forms part of most people’s financial portfolios. “Understanding which debts add value, and which erode your wealth, helps you to plan more efficiently,” she notes.
“However, not all debt is easily classifiable – it depends on your circumstances,” she adds.
“Using a loan to buy a car is not always bad debt, especially if you use the vehicle to get to work, but you need to make a sensible purchase because cars are depreciating assets.”
Bad debt vs good debt
Bad debt, such as personal loans and credit card debt, comes with high interest rates. You may end up paying double the cash value of the item, cautions White.
Buying luxuries on credit, in particular, can lead to a downward spiral, where you spend more than you earn to pay your creditors, she notes.
Menge agrees. “High-interest debt, such as credit card debt, has the potential to ruin you financially,” he warns.
Good debt, however, generally attracts a lower interest rate and allows you to fund an asset or provide an income stream.
“If you manage your debt well, your credit score goes up, which may allow you to get a home loan [for example] at a good interest rate,” Menge explains.
Making smart credit choices
Financial literacy is about more than knowledge. It also involves understanding what’s happening in your own “financial universe”, says White.
“Know your credit score, review your current debt commitments, and understand the interest and payment terms. Before entering into a new loan agreement, understand the terms and conditions,” she advises.
Menge and White offer the following tips to keep you free of bad debt.
- Ask yourself if taking on debt will make reaching your financial goals easier or more difficult.
- If you can’t afford to pay cash for a non-essential item, do you really need it? Just because you can take on debt – for example, a car loan or credit card – doesn’t mean you can afford it.
- Develop a budget and understand your income, fixed and variable expenses, and essential and non-essential costs. This will give you a clearer idea of your disposable income.
- If you’re already in debt, try to boost your income, or sell items to fast-track your debt repayments.
- Save as much as possible, as this will help you reduce your debt burden if you need a loan. Stashing funds for a deposit on a home loan, for example, will reduce the amount you need to repay, saving you thousands of rands in interest. It could also help you get a lower interest rate on your loan.
- Shop around at different banks to get the best possible rates for credit.
- Your situation is unique, so consult a finance professional before making big financial decisions.
Tip: Find out what your credit score is to understand your creditworthiness.