What is bad debt?
& is there such a thing as good debt?
Taking on debt has a bunch of negative associations. However, debt can be a helpful way to increase your earning potential, grow passive income, or otherwise invest in a financially stable future. Sometimes, it’s necessary to protect your health or wellbeing. When managed responsibly, good debt – including most student loans and mortgages – can be a clever thing to take on.
In contrast, bad debt doesn’t make a positive contribution to your life. Things like most automotive loans, credit card debt, and other consumer debts can be expensive to borrow and aren’t long-term investments. These sorts of debts usually come with high interest rates.
Just like many things in life, it’s not always easy to clearly define “good” versus “bad” debts, so there are a few grey areas.
What’s the difference between good and bad debt?
Though the line between good and bad debt can get fuzzy, there are some things that tend to differentiate the two. Things to consider when comparing good debt versus bad debt include:
- Does the debt still make sense after considering the total cost of the loan? (Think: fees, principal, interest, and any missed investment opportunities)
- Along the same lines, is there a better way to spend or invest the money that will help you in the long term?
- Is this an investment that will produce long term income or growth (capital gain), or does it just offer a short term solution?
- Will you get more from the debt/expense than you put into it?
While some might argue there’s no such thing as good debt, taking out loans can still be a smart investment in your future. In general, good debt is that which increases your net worth or otherwise helps generate some sort of value. Good debt also typically comes with a lower interest rate than many types of bad debt. This means you can pay off the loan quicker and at a lower overall cost than high-interest debt.
Conventional financial gurus still usually suggest keeping good debt to a minimum — especially if you have dreams of financial independence or early retirement. However, with interest rates remaining stubbornly low (acknowledging most economists expect them to creep up a little) it’s fair to say plenty of conventional approaches such as this are being challenged.
Examples of good debt
Common types of good debt are listed below.
Education costs, especially through university, are generally classified as good debt. This is primarily because a degree, though expensive at the time, increases your long-term earning potential.
However, some degrees have a greater value than others. For example, Google offers affordable design and coding certificates that can land you a six-figure salary, while an expensive arts degree from a university might not achieve the same results. From a purely financial perspective, it’s best to balance the cost of a degree against your likely earning potential. Note: the cost of a degree also includes the missed earnings during the years it takes to get the qualification.
There are also plenty of far less expensive non-university qualifications that can lead to high paying careers.
A home mortgage is usually the largest loan someone takes out in their lifetime. Though daunting, shouldering this debt can be a great investment in your future. For this reason, home mortgages are generally classified as good debt. Likewise, debt associated with investment properties can put rent payments in your pocket each month while acting as a long-term investment — both signs of good debt.
Building equity in a home also gives borrowers access to a home equity loan, both of which can be responsible alternatives to more expensive forms of debt.
As with other forms of debt, it’s always best to evaluate your individual circumstances before signing up for a mortgage!
Though never easy, starting or buying a small business can be an incredibly lucrative investment in your financial and professional future. Plus, with plenty of uncertainty in the job market, owning your own business is one way to invest in yourself and limit your risk of getting made redundant.
Business loans are considered good debt if they increase your earning potential or help generate more income. If used on a side hustle, these loans can also reduce your reliance on an employer and have the potential to lead to more robust and sustainable income.
Naturally, starting a business can still be a risky venture and your investment isn’t necessarily safe. When deciding whether to take out a business loan — and whether it will be more good debt than bad — stick with loans that will help you generate instantly increased income for your business.
Business loans aren’t easy to get, and it’s common for small NZ business owners to borrow against their own home with a home equity loan to fund a business. This usually comes at lower interest rates too.
Examples of bad debt
Generally speaking, bad debt does not generate long-term income or otherwise increase your net worth. It is often used to purchase goods or services that do not have lasting value. Often, bad debt is associated with financing clothes, cars, electronics, holidays, and other consumer goods and services that lose their value quickly. Plus, bad debt frequently comes with higher interest rates, making it harder and more expensive to pay off.
Cars are one of the more famously depreciating assets because of their high upfront cost and rapid depreciation once driven off the lot. For this reason, financing for a new car is generally considered bad debt. What’s more, auto loans nearly always come with high interest rates.
Note that car loans can fall into a gray area, depending on the needs of the borrower. If you’re financing a sports car to use on the weekends, you’re likely dealing with bad debt. However, if you live in an area without public transport or bikeable roads and need a car to get to your job, maybe a modest car loan is an investment in your future success. In that case, just try to repay the loan as soon as you can without penalties.
Payday loans (sometimes called cash advance loans) are bad debt because of their high interest rates, fees, and short payback periods.
If you’re feeling strapped for cash and are considering a payday loan, consider asking your employer for an advance, borrowing money from friends and family, or working with a local credit union to find lending terms that fit your needs.
Be sure to spend a little time working on your budget, that’ll save you getting too cash-strapped next time around.
Credit card use can land you in a spiral of debt if you max them out or only make minimum monthly payments. If the interest is left to build up, it becomes more and more difficult to stay on top of those minimum payments.
However, in some circumstances, disciplined people can use credit cards for maximum benefit at little or no cost. For example, if you’re paying your monthly balance off on-time within the interest-free period that many credit cards offer, then they can generate significant cash back or rewards, and perhaps include other perks which most credit card users don’t realise– such as built-in travel insurance or warranties on purchases of goods made on the card.
Learn more: five smart ways to use your credit card
When evaluating what constitutes bad debt, remember that there is a grey area. The true cost — and value — of debt is likely different from person to person.
Debt consolidation loans
Using a new loan to consolidate your other debts can be a great way to simplify payments, reduce your interest rate, and lower your monthly payments. However, if you don’t also change your approach to budgeting and money management, you may find yourself struggling to make payments.
Many debt consolidation loans can also charge high interest rates or have other fees or stricter terms of early repayment, this can mean the total repayments are higher than the original debt!
Borrowing to invest
Borrowing to invest can be good debt for those who understand investing and are prepared to hang in there when markets take a short-term dive. However, borrowing to invest is not a good idea for novice investors who panic when markets fall and may end up selling at less than the original purchase price.
The bottom line – what is bad debt?
Taking on debt usually has a bunch of negative meanings.
Despite this, some things qualify as good debt because they can help you grow financially. Buying a home, getting a degree or funding a course, or investing in a business or real estate can all be effective ways to expand your income or assets. To make the most of your cash, avoid bad debts — like credit cards and car loans — that can sap your financial resources without improving your bottom line.
Learn more: how to get out of bad debt