Written by Shekinah Ade-Gold on behalf of Budget Leaf
You may have often heard that debt should be avoided. In fact, you have probably heard that there is a difference between good debt and bad debt. However, how can we tell which is which?
When we decide to pursue a material object, a course of study, or some real estate – anything at all – we usually have to be able to spend money to do so. Sometimes we may have the money on hand to accomplish this, and at other times, we will have to borrow the money and owe our lender. The position of owing a person or institution money for the acquired thing is what is called being in debt.
Good debt can be seen in a variety of situations. For example, if I go to school for a medical degree and take a loan to do so, this would be good debt, since upon entering the professional world of work I would be able to earn enough money to repay my loans within a reasonable amount of time. This would leave me with even more money saved after repayment, and if I borrowed at a low interest rate, then it would work out in my favour.
The same can be said for paying the mortgage on a house, as I can live in my home for a few years then sell at a profitable price, or rent out a building residentially or commercially and earn from that as well. Good debt can also be found in entrepreneurship, as once a new business starts to make profits, the debt owed for starting up can be cleared within good time. The idea is that the thing you are going into debt for should be able to bring you enough financial returns that will clear what you owe and leave you with significant earning power afterwards.
On the other hand, bad debt can be found when someone purchases high-end clothes, shoes, appliances, vehicles and food and they take a loan or use their credit card to do so. None of these items are assets, so they are not able to continually generate income for you; even if you resold them for cash, the amount you received would typically be less than what you paid for them. Bad debt can also be seen when students take a loan to study for a degree with low demand in the job space, as employment will be hard to find afterwards and this can increase the amount that has to be repaid due to interest adding up over time. Borrowing to start a business with a low chance of success can also lead to bad debt.
In order to ensure that one only takes on debt that is beneficial in the long run, you would just need to consider if the money being owed can be easily repaid by the item, qualification or business that you are borrowing for. A house appreciates in value, which means it’s good debt, but a car will depreciate leading to bad debt. Borrowing money to buy video equipment for a wedding business could be an investment (good debt), but using that borrowed money to go on a trip or get an expensive new TV to watch your favourite show could be considered a loss (bad debt). It is important that we choose wisely.