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Jun 2015

The Difference Between Good and Bad Debt

June 20, 2015
Capify Australia

The word “debt” in itself already presents a negative connotation. In fact, most people would rather not have this associated to their name, as if it’s a serious liability on their part. While there is a certain truth to that, admittedly, there is, actually, a good side to debt.

Essentially, what makes the difference between the two actually lies on where or what the money is used for. Therefore, debt in itself is actually value-neutral; it is how it is utilised that makes the relevant distinction between which version and form will it take on.

What is Good Debt?

This is the kind of debt that you shouldn’t mind having. Yes, you will still owe something to someone, but the trade-off is that this loan is expected to reap the borrower some significant benefits or ROI in the long run.

Basically, what makes a debt good is how it will impact your overall financial situation in the future. For example, a student loan can be considered a good kind of debt because the loan allows the student to get a higher education. Although there is no absolute guarantee that they will be getting high-paying jobs as soon as they graduate from university, what is important is that they are able to improve their chances simply by getting a degree.

Another example would be a business loan. It’s highly unlikely for people to use their personal funds to start up their business. Most of the time, the cost of the venture is just over and beyond the available funds of the entrepreneur, such that they will need to resort to borrowing money from financial institutions.

Despite the anticipated responsibility of dealing with regular loan payments, the returns could very well be worth it, especially if the investment pays off, and the business becomes a huge success. Then and there, the loan becomes simply a necessary stepping stone in order to achieve these objectives of financial and business triumph.

Basically, a debt can be classified as a good one, therefore, if it will be yielding benefits to the company in the long run. There is also an expected appreciation of value to the object or cause wherein the debt was used for, such as the examples cited above. Taking all these into consideration, then, a debt is not necessarily something to run away from.

What Debt should be Avoided?

On the other end of the spectrum is the bad debt, or the type of debt that most people are familiar with. Simply put, this is debt that results not only to a depreciation in value of the investment over time, but also causes the debtor to suffer under the burden of dealing with its payments.

Financial experts and advisors would tell folks that reliance on debt for the purchase of everyday, mundane things, such as dinners or vacations, are at the root cause of accumulated bad debt. The primary medium for this, of course, is the all too infamous credit card.

The concept of the credit card was originally intended to make it much easier for consumers to spend—cashless transactions not only promise security, but also convenience for the modern shopper. Then again, because it’s become so easy for anyone to use a credit card and shop, that’s when the bad habits form, leading people to indiscriminately use their cards, forgetting that they are, in fact, spending money not their own, but the bank’s.

Because it is in the form of an easy-access loan, therefore, it is expected to have interest rates that certainly don’t come cheap. Sometimes, it gets to a point that the payments have backed up so bad, and the interest rates have gotten so big, that the monthly payments being made, albeit religiously, are only sufficient to cover the interest rates, but not the principal.

Experts would say, therefore, that credit cards are only ideally used for emergency situations. Dinners, movie night outs, and shopping for items that will certainly be of lesser value a few months down the line, are definitely not good reasons to swipe that plastic, although it can be a tad tempting for its convenience.

Other people, in fact, also take out loans for the simple purpose that they would like to go on a vacation. On that, expert advice would be to hold off on going on that vacation. If you don’t have the money for your dream trip such that you will have to take out a loan for it, then you probably shouldn’t be taking that trip in the first place. In a nutshell, therefore, prioritise your spending and costs, and avoid incurring bad debt.

When does Good Debt Become Bad?

While there are debts that can easily be classified as either good or bad, there are those that start out good, and then later turn bad. This scenario is most likely to happen in either of these two ways: depreciation of the item/investment value or the disproportionate growth of interest against the principal value of the investment made.

As an example for depreciating value, say a loan was taken out for a car payable within 5 years. On the second year, however, the car was written off in an accident, leaving the debtor-owner with additional expenses. Because the debtor-owner has not even maximised the number of years it will take to pay off the car in full, and with its value practically non-existent because of its damage, then it becomes a bad debt. Assuming that the car was still saved through repair, they will still have to pay for its complete cost as it was when it was first driven out of the shop, regardless of its current state. The value of the car has greatly depreciated already, therefore, but the payments will still have to be made as regularly as it was before.

When it comes to a financial imbalance brought about by high interest rates, it can easily become a bit more tedious and frustrating, especially because it would feel a lot like taking one step forward and two steps back.

Let’s say a business loan was taken out for a store’s improvement. The projection is that the business will earn 10% more with the expansion. On this information alone, it would seem like taking out the loan is a great idea. However, if you don’t consider the fact that the interest rate of the loan is at 30% then it becomes more irresponsible to go through with the loan. Because the profits expected don’t match the interest rate alone, what should have been a good debt therefore becomes a bad one.

At the end of the day, there really is nothing bad in taking out a loan, especially if it is for endeavors that are likely to create a business opportunity, or if is made on an item that appreciates in value. Keep mindful of your bills and due dates, though. Otherwise, you might be faced with nothing but bad debt, despite the good start you already had.

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