Before you borrow money, it’s worth knowing the difference between good debt and bad debt. Some things are worth going into debt for, others can leave you in a big financial mess. Here’s how to tell the difference.
What is good debt?
In simple terms, a good debt is one that is a sensible investment in your financial future, should leave you better off in the long-term and should not have a negative impact on your overall financial position.
You will have a clear and specific reason for taking it out, and a realistic plan for paying it back that allows you to clear the debt as quickly as possible, or in a series of regular and affordable payments (eg for a mortgage).
Someone with a good debt will also have identified the cheapest possible way of borrowing that money.
They’ll have done this by finding the borrowing method, an interest rate, loan or credit amount, term and charges that are the most appropriate for them.
In some cases, it will mean a deal with the lowest possible interest rate, but in others, it might not.
For example, if the lowest rate comes with the price of high charges or penalties.
Examples of good debt
Here are some examples of how taking on debt could actually make you better off in the long run:
- Student loan: taking out a student loan to pay for university will help you become a graduate. This is a good investment because university graduates typically get paid more than non-graduates and, more importantly, because the interest rate is relatively low and you only have to repay the loan once you’re earning more than a certain amount.
- Mortgage: a mortgage can be a good debt because it will enable you to purchase a home to live in. Once that mortgage is paid off, that home will be a big financial asset, which is likely to grow in value over time and the monthly mortgage payments could be cheaper than rent.
- Investing in your own business: a loan to help you develop your own business can also be a good debt, as long as you have a sensible and realistic business plan. If your business does well it will end up being worth far more than the loan you originally took out.
- Buying a car you can afford: if it is essential to enable you to get to work and earn a living. However, it’s important that you can afford the loan repayment costs and the running costs of the car out of your income.
What is bad debt?
Bad debts are those that drain your wealth, are not affordable and offer no real prospect of ‘paying for themselves’ in the future.
Bad debts are also likely to have no realistic repayment plans and are often run up when people make impulse purchases of items they don’t really need or borrow money to pay everyday bills.
If you can’t afford to borrow the money (for example, you aren’t sure you’ll be able to make the monthly repayments) it is definitely a bad debt.
Examples of bad debt
Here are some examples of things you should think seriously about getting into debt for.
If you can’t pay the debt off in the very short term, it’s probably better not spending the money.
- A luxury holiday you can’t afford: a luxury holiday can be a trip of a lifetime but is best avoided if it’s accompanied by a lifetime of debt. Instead of getting into debt, try and save up first, if necessary reworking your plans so you can still take a holiday, but one you can afford.
- A brand new car you don’t need: If you don’t need to buy a new car, think twice about it. New cars always lose their value and if you lost your job for example and you couldn’t keep up the repayments, you might end up with a loan for more than you could sell the car for. That means you’d have no car but an outstanding debt (and interest) to pay.
- Borrowing money to pay bills and or other credit: if you’re struggling to get to the end of the month you can get free confidential advice, which will help you get your finances back on track.
Tips to avoid bad debt
When considering borrowing money, ask yourself the following questions.
If any of the answers are ‘no’, that debt is likely to be bad.
- Have I shopped around to get the best deal?
- Am I borrowing this money as cheaply as possible?
- Will I be able to cope should interest rates rise in the future?
- Will I comfortably be able to afford the monthly repayments?
- Will borrowing this money improve my finances in the long run?
- Do I understand the risks and what could happen if things go wrong?
- Do I understand all the terms and conditions associated with borrowing this money?
How much should I borrow?
Once you have established that the money you want to borrow is a good debt, you need to work out exactly how much to borrow and how you’re going to pay it back.
Borrowing more than you need without a plan for paying it back, can swiftly turn a good debt bad.
This article is provided by the Money Advice Service.