The difference between good and bad debt
“The main reason people get into ‘bad debt’ this situation is because they use credit to fund a lifestyle that they cannot ordinarily afford. Credit is a great tool to assist people to purchase items that their regular cash flow does not allow, but when it is used to live beyond their means it can quickly become a financial and emotional burden,” revealed Theunis Kruger, head of unsecured lending at Standard Bank.
“Using a loan wisely can actually be beneficial in many ways - the trick is to view the use of credit as a tool to invest in your future rather than a way to live a life of luxury in the short-term,” added Kruger.
This is why it’s important to know the difference between ‘good’ debt and ‘bad’.
“Good debt can be defined as debt that is a strategic investment in your financial future. It should leave you better off in the long-term and should not have a negative impact on your overall financial position. Good debt is also underscored by the knowledge that you have a clear and specific reason for taking it out, and a realistic plan for paying it back that allows you to clear the debt as quickly and cheaply as possible, or in a series of regular and affordable payments,” explained Kruger.
Good debt includes buying a house or other asset that will increase in value or assist in earning you more money. “The interest charges are offset by the growth in the asset. Using a loan to fund an education is also considered to be good debt, because it is an accepted fact that the better educated you are, the more earning potential you have,” reveals Kruger.
Other forms of good debt can include investments and starting your own business, as the long term goal is for the investments to generate wealth and the business to turn a profit.
Kruger noted: “Investing in a business can also be a smart use of credit, as long as you have a well-conceived and sustainable business plan. If your business does well, it will end up being worth far more than the loan you originally took out to finance the business.”
However, an article on Investopedia, highlights that there are no guarantees when it comes to debt, and even good debt can go awry.
For example, the author of the article, noted that following the global financial crisis, global real estate prices dropped, teaching many that price appreciation is not guaranteed.
The article also highlights how borrowing money to invest it can be risky, as there is always the chance that you could lose a significant amount of your investment, in which case you might be worse off than you were before borrowing the money.
Bad debt on the other hand will deplete your wealth. Kruger pointed out that these debts often do not have realistic repayment plans and will not pay for themselves in the long-term (like a business or investment would).
“[These debts] are often incurred when people make impulse purchases of items they don’t really need or are [unable] to afford,” said Kruger.
“Using credit to fund non-essential lifestyle purchases may get you into dangerous territory. For example, if you want to go on holiday and you intend to use your credit card to fund the trip, working out how much the repayment will be and ensuring your income will cover the payments is fine. However, using your card up to the maximum with the knowledge that you will struggle to pay it back can get you into trouble. The rule is; if you can’t afford to borrow the money (meaning, you can’t make the monthly repayments) it is definitely bad debt,” added Kruger.
To help people determine if a debt is bad, Kruger suggested comparing the length of time the purchase is likely to be useful with the repayment period of the loan. If the repayment period is longer than the ‘useful life’ of the item, it would be considered bad debt.
An example of bad debt would be paying for your groceries on credit. You are essentially spending money that you do not have to buy items that will be depleted or finished before you can pay off the debt.
Additional examples of bad debt, according to Smith, include cars and clothing accounts. Smith highlighted that a new car is already worth less the moment you drive it out of the car dealership, yet you continue to pay interest on an item that is depreciating in value. Smith suggested either buying a second hand car in cash, or buying the least expensive yet reliable car that you can find and pay it off quickly. This will minimise the bad debt that you take out.
“All else considered, credit can be a valuable wealth-enhancing tool when you use it wisely. If you need help to ensure that you are using the appropriate loans for your purchases, speak to a bank consultant. They can help you craft the right combination of products for your needs,” emphasised Kruger.