Thursday, 23 June 2016
How to use good debt rather than bad debt
While debt is so difficult to avoid, we're usually advised to try and steer clear of it, and to eliminate it as soon as possible if we absolutely have to borrow money. So the idea that there is such a thing as good debt may come as a surprise to you.
Knowing the difference between good and bad debt in the context of an overall financial strategy is an important part of reaching financial stability or generating wealth.
What is bad debt?
Bad debt comes in a few forms. The most basic form of bad debt is money you borrow that you can't afford to pay back. We usually incur these debts when we make impulse purchases or buy something that we know we shouldn't, but can't resist.
Another common form of bad debt, which emerges particularly when times are tough, is the buying of consumable items like food or disposable products using a credit card. The problem here is that you're paying a high interest rate for non-durable goods, and unless you pay back the debt within the allotted time, your cost of living will shoot up, as you are paying so much more for the everyday basics.
One of the most popular forms of debt is, unfortunately, also bad debt - our credit account at our favourite clothing store. This is another example of borrowing money at interest to buy things that don't hold their value and end up disposable.
So what is good debt?
Types of good debt
Good debt is money that you borrow in order to generate wealth - to make more money. It is the type of debt that builds wealth over the long run, leaving you better off than you were. It is effectively an investment.
The most important aspect of a good debt, therefore, is that it must generate some sort of value. This can be tangible, in the case of a profit made, or less measurable, like the benefits of an education.
There are several types of debt that we generate wealth or serve as an investment.
The first and arguably the most beneficial form of good debt is educational debt, in the form of money you borrow to pay for an education. The reason why this is a good debt is that the education will most likely allow you to generate more income than the value of the loan. In other words, you'll make a profit, if we measure it only in financial terms. Of course, education has plenty of other benefits, which further increase its value and make it a good debt.
A house bond is another form of good debt. It is a straightforward investment in something that increases in value over time: property. The vast majority of home owners sell their properties for more than what they paid, making this form of debt a solid investment. The other benefit of having a house bond is that it allows you to borrow further money against it, which increases your financial flexibility - as long as the other debt you incur is also good debt, of course.
Yet another type of good debt that can improve your financial status is refinancing. If you are paying off a number of different debts at relatively high interest rates, it will become a lot cheaper if you are able to borrow a single sum at a lower interest rate, with which you can pay off the rest and only have a single source of debt.
Learning the good debt lesson
Now that you understand the difference between good debt and bad debt, and how good debt can be used to create wealth, you'll be able to make smarter financial decisions.
Start by reviewing your current debt - are you paying off a lot of different debts? Are some of the interest rates really high, compared to others or to the prime interest rate? If so, it might be worthwhile approaching a financial institution for a consolidating loan at a better interest rate, to end up with a single loan that will cost you less.
Next, look at your future plans and how you intend to fund them. Look at the all of the things that you will need to go into debt to achieve, and check whether they will cause good debt or bad debt. If the latter, try to find a different way to reach your goal.
And don't forget to look for opportunities. For instance, you might not have yet considered buying property, because you're scared of the debt. Now that you know this is good debt, you can take it on with more confidence, knowing that it will actually make you money.