Difference Between Good Debt and Bad Debt

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Almost everyone has had a debt at some point in time. These can be personal loans, business loans, mortgage, or its various other types. Our growing, excessive wants, coupled with overzealous credit marketers are at play here. Borrowing is not a problem. However, if one is not able to pay back loans, and if one needs an ongoing series of new loans to pay back the last one, then it is a bad debt spiral.

Because of this, it helps to separate Good debt from the bad debts, which aids in keeping your obligations under control.

Let us first look at what Good debt is.

What Is Good Debt?

You may be confused at this point. After all, we were told that all debt is bad.

So from where on earth does the notion of Good debt come? Can debt be good? And what is bad debt then?

Good debt is something that enables you to make more money. You can practically gain an income through it. Thus, good debt is very similar to an investment.

One more good thing about it is that it has very low rates of interest.

Are There Any Examples of Good Debts?

Home loans are a great example. These are cheap and easier to get in the market. Home loans also come with several tax benefits. When you buy a home, you are getting an asset. This asset can give you more money in the future through value appreciation.

Another example is an education loan. Getting a good education will pay off in the long run. Getting a loan for education is a good investment, and also a Good debt.
Types of Good Debt

Some types of good debt are: 

  • Mortgage

  • Student loan

  • Small business loan

  • Credit cards

Are Good Debts All That Good?

Good debts are excellent as long as you use them well. The problem arises when there are too many good debts. What happens is that people often overextend themselves. 

For instance, a couple may take a loan to buy a dream house that is well beyond their means. Even when they get such a loan, it leaves very little monetary maneuvering space. There may not be enough funds for meeting an emergency, as they would need to sacrifice a significant part of their income to pay back the loan.

 

The solution? Make down payments of 20% of the property at least, while limiting borrowings to a minimum.

Now that we have learned about Good debt, it is time to learn about bad debts.

What are Bad Debts?

Bad debt, as the name suggests, is the opposite of Good debt. While the latter creates more money for you, the former leads you to depreciating assets. A car loan is a classic example of this.

Car’s by themselves have value depreciation. Did you know that the moment you buy a new car, its value depreciates by 20%?

Consumer loans, personal loans, and credit card loans are also examples of bad debts. When you buy anything that you otherwise can’t afford with a consumer loan is bad debt. It is not a smart financial move either. 

Paying your credit card bills on time is excellent, but not so when you start delaying the payments. In the latter instance, it also adversely affects your credit score.

Don’t Use Good Debts to Pay off Bad Debts

It may seem normal to get a new loan to pay off a previously taken loan, but it is not a smart thing to do. You may get a lower interest rate when you get a remortgage, for instance, but that will not be a smart financial decision. This is because your home will still be kept as collateral, meaning it will be taken away in case you are not able to repay this loan. The second problem is that a remortgage stretches out your repayment period.

While you can surely consolidate multiple debts, doing this puts your most prized assets at risk.

Keep an Eye on Your Debt-to-Income Ratio

You need to keep an eye on this ratio as well, because this is one factor that directly affects your Credit Score. A good rule of thumb is to make sure that EMI payments are 35% of your take-home income.

To Conclude

Hardliner economists and financial experts may say that all debts are bad, but that is not true. It all comes down to the type of loan, and how you use it. There are good loans, after all.

Try to use loans only to improve your earning potential and to invest further for your future. Using these for instant gratification is not the way to go. 

It is much more prudent to keep debts within safe limits. That way, debts won’t affect your savings.

 

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