Types of Debt
Good Debt or Bad Debt?
There are two types of debt, good and bad, but how do you know the difference between the two?
What is debt?
Debt is a legally binding I Owe You. One party has agreed to lend the other party money (Principal) with specific repayment terms. Terms such as the duration of the loan and the amount of interest to be paid. The party receiving the funds agrees to the terms and paying back the principal.
As well as any interest fees that occurred from receiving the loan. Commonly lenders are either banks or financial institutions, they conduct thorough credit checks for potential borrowers. These checks help reduce the risk of the borrower defaulting on the loan.
Debt in itself is not always bad, how the debt gets used dictates whether it is good or bad. In the simplest terms, bad debt costs you money, while good debt assists you in making money.
Generally speaking, bad debt is where you go into debt for a non-income generating asset. Or for something that won’t add any future value, or will depreciate in value.
Credit Card Debt:
Often referred to as one of the worst kinds of debt available, it can be easy to obtain a credit card. The interest rates on credit cards are very high at an average of 13%. Credit cards if used correctly though can really help manage cash flow problems. They can also provide lots of bonus points for travel rewards programs such as Bank of America, to assist in cheap travel.
Credit Cards become dangerous If you are not able to make the payments within the interest-free period. It can become difficult to manage how much you are spending, as available funds aren’t easily visible. Credit Cards can create the habit of spending money before you have the funds available. This is how Afterpay was able to be so successful in a short period of time.
Taking out a loan to purchase a car is another form of bad debt, as the asset depreciates in value. An exception is if you taking a loan to make money driving your car, such as an Uber driver. In most cases, however, people take out a car loan to help them purchase the latest model they desire.
Car value depreciates as soon as it leaves the dealership and continues to decrease over time. Car loans also attract high-interest rates, which makes them quite expensive options.
One argument to the car loan being bad debt is that it provides you with the freedom of transport. This freedom of transport can provide you with the ability to earn money. It is our belief though, that you could choose a cheaper alternative where a loan is not necessary. Examples include a bike or an e-scooter.
Good debt is where you take a loan for an income-producing asset. Or for something that will add future value, whether it be capital growth or increased knowledge. Some examples include:
Investing in your education is the best form of debt, investing in your education is the best investment available. The loan you take out will pay for your education, whether that’s college or online. This education will provide you with a skillset or degree that will increase your work opportunities. Greater work opportunities will lead to greater pay and you will reap the benefits of your investment.
In some cases, you may not specifically use your degree, but it is often looked upon favourably. In other situations, you may be required to specialise further (think medicine/law) before you can earn income. Either-way, investing in yourself and your education is a great example of good debt.
A mortgage is a loan from a bank or financial institution that enables you to purchase a property. Usually, you put up a certain percentage of the property amount (15-20%) and the bank provides the rest as the loan. You will work to pay down the principle amount and the interest on the loan over a set term, usually 30years.
A mortgage is a good debt, as it provides you with the opportunity to have a passive income-producing asset. You have the option to rent out your property, a room in the property, or even just your parking spot! There is also capital appreciation if the house becomes more valuable, due to an increase in the property market.
A mortgage remains good debt, provided you are able to meet your mortgage repayments. Similar to credit cards, if you miss payments you will be hit with penalty rates, and even face foreclosure and eviction, which obviously turns it into bad debt.
Bad debt costs you money, good debt assists in making you money. Examples of bad debt include car loans and credit cards and examples of good debt include student loans and mortgages. Loans switch between good or bad debt depending on your ability to meet the repayments. This is regardless of whether it is generating income/value or not.
Only look to take out loans if you have calculated your budget and expenses and have figured out that you will have enough cash flow in order to cover the repayments. Otherwise, you should stay clear of any type of loan until you are able to do so.