Bad debt and good debt
There are different types of debt
Sometimes going into debt can be a good thing, and even a necessary thing. It’s pretty hard to buy a house without taking on debt, or set yourself on a great career path. Other times, debt is just plain old bad news. The difference between bad debt and good debt can get really confusing, and sometimes they can merge into each other a little bit. Andy has written this handy wee snapshot guide to help you get your head around some of the different types of debt. Remember, one of the most important tools you have for managing your debt is an understanding of what you’re dealing with. The better you understand the debts you have, the more efficiently you can pay them off.
Let’s start on a positive note with the good debts!
Tell me more about good debt
So how do we define good debt? Basically, good debt is a debt that will help you make money, or increases your net worth.
Three common examples (and how they might become bad if you’re not careful):
- Student loan. Usually good debt because it can set you up for a career and therefore income. In many countries around the world, student debt is also interest free (luckily this is the case for us in New Zealand, Em’s student debt is huge).
- Mortgage/property. Also usually good, because property is a pretty stable investment that will hopefully increase in value, therefore increasing your net worth. After getting married last year, Em and I bought our first house together, and we’re feeling really chuffed. Caveats to this are making sure you’re not paying an overinflated price for the property, keeping in mind the cost of maintaining it, and being confident you won’t default on your payments.
- Your own business. If you’re careful with your business plan and don’t over-invest, this can be one of the best debts you ever get into. If you can become financially independent and in charge of your own income, you’ll be debt free in no time. Em and I are both working towards our own businesses. We share this one, Em has a weight loss website, and I’m working on my business plan to strike out as a self employed electrician. Exciting times ahead for us!
Tell me more about bad debt
What’s bad debt then? It’s basically the opposite of good debt. It is debt that will not make you money, or takes away from your net worth.
Three common examples (and how you can use bad debt for good):
- Credit cards. The danger with credit cards is that you are spending money you don’t have right now. And then you have to pay it back. With interest. This can soon get into a bit of a spiral, particularly if you find yourself taking out multiple credit cards. This will massively drain your net worth, and certainly won’t make you money. On the flip side, if you’re smart with your credit card, it can work in your favor. You can keep money elsewhere, earn interest on it, then use that account to pay off your credit card. An example from us: we purchase all our groceries and pay for costs of daily living with our credit card. We budget the heck out of it to make sure we are living within our means. Doing this keeps our checking account looking healthy, which saves us interest on our mortgage. As soon as our mortgage payment is gone, we pay off the credit card bill before the monthly interest is charged. So our credit card works hard for us and we save on two different interest payments.
- Cars. If you buy a new car, it is devalued as soon as you drive it off the lot. This is not going to make you money! Buy a second hand car and save yourself a ton of unnecessary debt. Em and I have never owned a new car in our lives. We currently have a very trusty Toyota that just goes and goes. She ain’t the prettiest car out there, but she’s reliable and that’s good enough for us!
- Commodities. This covers things like clothes, luxury items, fancy holidays. Alright, we all need clothes, but think about the durability of the piece you’re purchasing, and the value for money it represents. Same with luxury items. Do you really need it? Or are you just trying to keep up with your friends (stick with us and we’ll teach you how to get ahead, don’t worry about other people). We all need a holiday from time to time, but putting yourself in debt for it will lead to longer term stress. Ask yourself what you really need from a holiday and make your plans from that.
What to do moving forward
Think about the debts you have, write them down. Do you classify them as good or bad? Can you turn them around, and make good from a bad debt (see the credit card example above)? If you’ve identified some bad debts on your list, these ones are going to be your top priority when you start downsizing your debts. Visit our ten tips to reduce your debt to get ideas to start reducing that debt today.
I hope you’ve enjoyed reading this article, please feel free to comment below if you have anything to add. I’d love to hear from you.
Photo by Markus Lutkemeyer, CC 2.0, https://flic.kr/p/BQYvP