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Do you know the difference between good and bad debt? If you don’t this blog is for you
So you’ve borrowed some money, that’s not unusual, most of us have. But, do you know whether your debt is good or bad debt? Did you even know there’s a difference between the two? If you do, you’re on the ball, well done! If you didn’t, this blog should make it all clearer for you.
So let’s look at the good types of debt by first explaining what we mean by ‘good debt’. Good borrowing is the debt that you have taken on so that you can have a better life, either now or in the future. It’s more like an investment, and should leave you better, not worse off, in the end.
This is the kind of borrowing you’ve thought about long and hard and you know exactly what you’re borrowing, why you’re borrowing it and what you hope to achieve with the money. You should have a clear idea about how you’re going to pay the borrowed money back and you should, especially if the money is attracting any kind of fee or interest, aim to pay it back as soon as possible. This helps to keep your cost of borrowing as low as possible.
In fact, part of what makes borrowing good, rather than bad, is that you’ve made the effort to find the best way to borrow for you, which could be a loan, credit card or some other kind of borrowing, from family for instance. You’ll also have checked to make sure that your borrowing in the cheapest way possible for that purpose. And that doesn’t mean you should just choose the cheapest deal in terms of interest rates. Sometimes borrowing with very low interest rates has other ways of catching you out and clawing back some of the money you’re saving by charging extra in other areas. So, you could have a great interest rate, but if you’re in a position to pay what you owe back early, or you miss or pay late one month, you may find that there are huge charges added on to do this.
Some examples of good borrowing:
Mortgage – this is the ultimate in good borrowing, as long as you were given the best deal available to suit your needs at the time. Why is this good debt? Because the money you borrow is going towards paying for something that will be yours when you’ve finished paying for it. And, with any luck, by the time you get to the end of paying the mortgage, the value of your house will have increased. Of course, this doesn’t always happen, but even if it doesn’t, you’ll still be the proud owner of your very own bricks and mortar.
Student Loan – this is another investment, as you would hope that once you’ve completed your degree, you’ll have greater earning power, and be more than able to pay back what you borrowed. In any case, what you borrowed is at one of the lowest rates around, and you’ll only start to pay it back when you earn over a certain amount of money.
Buying equipment – if you need a car to get to work, and you stick to a budget that you can afford, then it’s a great investment if it’s cheaper, and easier, than taking public transport. In fact, any equipment you buy that you use to earn you money, a set of decks for being a DJ in the evenings for example, or equipment for you to go rock climbing, if you aim to be a climbing instructor in the future, is a good investment and, therefore, good debt.
Investing in your business – the justification for this is much the same as for the previous point. If you own a painting and decorating business and you borrow money so that you can purchase better equipment, it’ll make your job quicker and more paint efficient, so it’s worth it. In the long run you’ll be saving time and money.
Bad debts are pretty much the opposite of what you’ve just read above. They’re made up of high interest, unsuitable borrowing, that’s often unaffordable for the borrower. And very often it’s for impulse purchase items that you don’t really need. Even worse is if you’re in a situation where you need to borrow to pay your bills. Whatever the money is used for, it’s almost certainly for things that won’t pay for themselves or give you anything back in the future.
It’s also borrowing that you’ve taken on without making sure you’d shopped around for the best rates for your purpose. And you’ve probably not planned for it either, so you’ll have no definite way of paying it back and no intention of paying it back in the shortest time possible. This means you’ll probably be paying the minimum amounts each month, which will result in more interest being added on to what you’ve borrowed as it’ll take longer to pay it all back.
Some examples of bad debt are:
Credit to pay bills – we know we’ve mentioned this already, but it’s really important so we’re going to say it again. If you’re borrowing to pay your normal household bills each month, you need to have a think about your finances and complete a budget so you can find out where your money is going. If you find that you don’t have enough money to cover your outgoings on a regular basis, you should speak to a debt advisor about ways to manage your problem debt.
It’s also important to realise that forms of borrowing that are thought of as being bad, like payday loans, may only be bad if you use them inappropriately – for example, you find yourself relying on them for a long period of time. If you turn to a payday loan to cover you for a few days, but you also know how you’re going to pay it back, there’s nothing wrong with that – although, you should always look to see if there are cheaper ways of borrowing, such as getting an overdraft from your bank.
A car you don’t need – if you don’t need a car, because you can walk or get public transport easily to work, it would be frivolous to get one. It would also be a mistake to buy a car you can’t afford, just because you happen to love that model. And, as cars are notorious for losing value quickly, it’s almost guaranteed that you won’t get back what you paid for it. Unless, it’s a rare car, a classic of some kind, that’ll be in demand by enthusiasts or something similar.
Holidays that are out of your price range – this is another way to get yourself into some serious bad borrowing. And, if you have a terrible time while you’re there, you’ll be kicking yourself even more when you get home and the bill arrives.
Borrowing more than you need – once you’ve decided to borrow, you need to work out exactly how much you need, and then only apply for that amount. Don’t be tempted to take more and then spend it on treating yourself. This mistake can easily turn what was a good debt into a bad one.
If you want to avoid bad debt, it’s probably best to ask yourself these questions before applying for any credit:
1. Do you really need to borrow, or could you save for whatever it is you need?
2. Have you made sure you’ve worked out the minimum amount to take to achieve what you want?
3. Can you afford the monthly payment easily?
4. Have you shopped around for the best deals?
5. How do you plan on paying the money back?
6. What will happen if the interest rate rises and your payments go up?
7. Have you read and understood all the terms and conditions associated with the borrowing?
8. Are you sure you understand what the process will be if you don’t manage to keep up with your payments?
If you have answers that you’re satisfied with after these questions, great! If you’re still not sure, whether borrowing is the best solution to your problem, why not sit down with someone else and ask them to go through your plan with you, and the answers to these questions, and give you their honest opinion about whether they think borrowing is a good idea or not.
If you’re already struggling with problem debts, why not give one of our trained debt advisors a call. They’ll be able to go through your finances and advise you whether you need to think about a debt solution. And, if so, which one would be the most suitable for you. You can contact us easily using the links on the left of the page.
by Shelley BowersBack to blog home