In the minds of many, all debt is bad – no one enjoys paying the bills, after all. But in actual fact, the world of debt is a bit more complicated. Understanding the difference between ‘good’ debt and ‘bad’ debt is really important to managing your finances properly, and in this article we’re going to look at some examples of the two types. With this knowledge under your belt, you’ll hopefully have a better idea of when it’s a good idea to take out a loan, and when it’s a good idea to put that planned expenditure on the backburner while you save up a bit more.
Good debt can be loosely defined as money borrowed, then spent on something that will accrue value in the future. The classic example is a mortgage. With the nearly inevitable yearly rise in house prices in the UK, you have some reassurance that even with hundreds of thousands worth of money owed, you have sufficient collateral that – should the worst come to the worst – you would be able to recoup the money to repay.
Another example of good debt could be a student loan. While the degree you receive might not have resale value, the potential increase in future earnings mean that your spend on tuition fees and living costs while studying can be looked on as a good investment.
But good debt doesn’t have to come with the potential of a future windfall. Taking out loans for one-off necessities – loans which are, most importantly, within your power to repay – can also be looked on as good. That’s provided you know that the expenditure will not be a recurring cost and have a plan in place for repayment (which doesn’t involve further loans).
On the other side of the coin, you have bad debt. This is money owed that you’ve accrued buying something that will fall in value over time, or something where there’s no prospect that you’ll be able to make any of your money back from it. A good example are car loans – it’s often the case that people will upgrade their cars and refinance time and time again, but they’re always losing money, since cars never re-sell for more than their original price. In fact, from the moment you drive a brand new car away from the dealership, you’ve already lost thousands of pounds in value.
Holidays are an even worse investment from a financial perspective – while cars can be resold at a loss, a trip abroad lives on only in your memories! Buying a holiday on credit is definitely bad debt, and should be avoided at all costs. Taking up and using store credit cards for clothes in order to get a discount (usually shops offer around 10%) is a bad idea too – like holidays and cars, clothes can’t be considered an investment, and any initial saving will quickly be eaten up by the interest on the card.
How to avoid bad debt
Now you know the difference between good and bad debt, how do you put it into action? The best way to start is by avoiding bad debt from the outset. Don’t take out loans to pay off loans, and never pay for ‘here today, gone tomorrow’ luxuries like holidays, festival tickets or designer clothes with credit. If you do take out a loan, make sure it’s within your means to repay it – if it’s a small loan, that’s a matter of doing your sums and working out where you can save the following month. If it’s a big one, make sure that whatever you’re buying is a good investment and will gain value in the future.