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Do you know the difference between good debt vs bad debt?
Consider all your current debts, from personal loans to your credit cards and mortgage. Now think about whether they will leave you financially better off in the future, or in a worse position than before.
If you’re comfortably paying off your mortgage and look forward to owning your home outright, or selling it for more than you bought it, then your mortgage is a good debt.
Struggling with loan repayments and paying on credit for luxury items that you can’t afford, are signs that you’ve taken on bad debts.
In this article, Cashlady explores how to identify good debt from bad, and explains why taking on bad debt should be avoided if you can.
Good debt vs bad debt
How can debt be good?
For many people, living with debt is unavoidable. Recent statistics from The Money Charity UK, show that the average UK household has an average debt of £56,460, including a mortgage.
While this amount of debt may seem high and potentially unsustainable, it depends on whether a household’s debt is primarily made up of good debt or bad.
Good debt is often considered a worthwhile investment. It’s money owed that’s manageable and usually part of a longer-term plan that will see it grow in value or generate a long -term income.
Before taking out the debt, the best interest rates and finance providers will have been explored, and a realistic repayment schedule created for paying the money back.
Examples of good debt
- Student loans
- New Business loans
Purchasing a home, going to University and starting your own business are all big, positive life changes that can bring ongoing success and enhanced financial stability – however they’re expensive.
Many people don’t have the money required to pay for them upfront and so are willing to take on initial debt as in investment into their future.
Taking out a mortgage
In 2016 Nationwide Building Society revealed that the average home in the UK costs £200,000, plus the additional costs associated with moving home, including solicitor’s fees, are estimated to be around £11,000.
Taking out a mortgage to cover most these costs, means taking on a large debt but also that a home can be purchased to avoid paying excessive amounts of rent that never see any return.
Once the mortgage is paid off the home becomes an asset and in the meantime, it might be sold for more than it was purchased, providing a useful foothold on the property ladder.
Taking out a student loan
Tuition fees for students in England and Wales are up to £12,000 for three years, plus living expenses, which vary between city.
While many students and their families don’t have the funds to cover this, taking out a low-interest loan, which is repayable after graduation, when a certain salary threshold is reached (currently £17,775,) provides vital access to higher education.
Along with the skills and knowledge gained at University or College, a degree often brings with it access to a higher salary.
Figures from Job search engine Azunda show that the average salary for accounting students is £42,040, for a student of engineering it’s £42,837 and future computer science graduates can expect an average pay of £41,950.
This is far higher than the average UK salary, which is currently £27,600.
A new business loan
The cost of starting a new business is also high, with research by Lloyds Bank showing that for businesses not based at home, an average £12,608 is required just to get it off the ground.
Starting a new business isn’t easy and there are many startling statistics about the number that fail within the first year.
However, with a brilliant idea, solid business plan and sound investment, a thriving new business will go on to provide a high income for many years to come.
Other examples of good debt
Good debt doesn’t always have to cover a significant milestone in your life.
Purchasing a car through finance so that you can commute to work at a better-paid job, or taking out a home improvement loan to renovate your bathroom, which will increase the value of your home, are both good debts.
Even if what you’re purchasing isn’t going to make you financially better off in the future, a well thought out and manageable debt, with low-interest rates and a clear repayment plan, may also be considered good.
Signs that you’re taking on good debt:
- You’ll comfortably be able to make repayments
- You’ve secured good rates with a trusted lender
- You have a clear repayment plan
- Once your debt is paid off you’ll benefit financially
When debt is bad
Bad debt is the type of debt that can leave you with sleepless nights, large chunks of your income barely covering minimum repayments, and a spiral of further debt.
Buying luxury items on credit, taking out debt to cover other debts and applying for high-interest loans, such as payday loans, are all examples of bad debt.
Even a mortgage or a new business loan can quickly become a bad debt if you find yourself unable to make repayments, or took on more debt at the outset than was sensible.
As opposed to leaving you in a better financial position in the future, these debts will drain the money that you have and leave you worse off.
Examples of bad debt
- Luxury items that you don’t need on credit
- Debts to pay off other debts
- Impulsive purchase
- High-interest loans
Luxury items on credit
Holidays, expensive clothes and designer handbags are items that you should save for.
Paying for these items on credit and getting into debt means that you’ll be paying interest on the balance on your credit card, making them even more expensive.
Unless you clear your balance in full each month, it’s likely that you’ll be paying off your credit cards for longer than the time spent enjoying the holiday or new clothes.
Debt to pay off other debts
Taking out debt to cover other debt indicates that it’s time to take control of your debts and overall financial situation.
If you’re struggling to repay a debt and require additional debt to make the repayments then it’s unlikely that you’ll comfortably make repayments on either. This is how you enter a potentially dangerous debt spiral.
Instead of taking out further bad debt, you should sit down, evaluate your finances and consider all the options available for repaying your debt and rebuilding your credit. You can read more about this here.
If your attitude to debt is relaxed and you’re familiar with, ‘popping something on the credit card’, or applying for a quick loan to cover a new item, then you might be an impulsive spender.
This isn’t an effective way to spend money and it certainly isn’t a sensible approach to taking on debt.
Getting into debt for things that you don’t particularly want or need and that won’t accrue any long-term value means that you’re taking on bad debt. You should think about why you are making impulse purchases and what you can do to stop it.
We’ve written about how to reshape your thinking around spending and learning to live within your means here.
Taking out high-interest loans
High-interest loans, such as payday loans, can be useful for getting you out of a tight spot when you have nowhere else to turn.
However, if you’re relying on high-interest, short-term loans to cover essentials, such as food or bills or other debt repayments then it’s time to stop taking on more debt.
Signs that the debt you are taking on is bad debt:
- You can’t afford the repayments
- You don’t have a clear plan for paying the money back
- The interest rates are high
- You need the money fast
- Paying off existing debt with the new debt
- You’re buying a luxury item that you don’t need
Why bad debt should be avoided
Bad debt will drain your finances and it won’t make you better off in the long run.
Where possible, you should save for items that you need or want, to avoid paying expensive interest charges and harming your financial stability.
If you already have a large amount of bad debt then it’s not too late. Consider paying it off gradually, starting with the debt with the highest interest rates first.
Rethinking the way that you spend money and take on debt will mean that you’ll be much less likely to take on any more harmful bad debt.