Good Debt Vs Bad Debt

Most sensible spenders will agree that it is not good to be in debt.  With rising costs and fear of job-loss, it can often be difficult to afford the basics without loans and credit card repayments sucking the life out of the monthly pay-check.

So the golden rule is to avoid borrowing money at all costs, especially if it is to be used for unnecessary luxuries like holidays, clothes or home consumables.

However there are a couple of exceptions to this rule and in these instances borrowing money can make financial sense, but only if the money enables you to grow your income or personal wealth.

These exceptions are known as Good Debts and include mortgages, business investments and loans taken out to help pay for further-education. 

Using Good Debts To Gain Leverage

Good Debts provide you with the money to take advantage of opportunities that you would otherwise have had to wait years to save up for.

Take buying a house as an example.  Not many people have the sort of money lying around in their bank account required to buy a home for cash and saving up that sort of money would take years; so instead they take out a mortgage, which enables them to purchase the property and re-pay the money over an agreed period of time.

Unlike taking out a loan to buy a car (which will only depreciate in value), borrowing money to buy a home generally makes good financial sense as property values have tended to hold and rise over the years, despite various fluctuations. 

Borrowing To Invest In A Business

Taking out a loan to start your own business is another example of a Good Debt.  If the business takes off and earns you a significant income or can be sold on for a tidy sum, it will have been well worth borrowing the money.

However, there is always the risk that the business will fail, leaving you stuck with outstanding debts.  To minimise the risk of failure, make sure you take the following steps:

  • Take sound advice from your accountant and other business advisers
  • Be sure you fully understand the business environment that you are planning to trade in (customers, competitors, legislation, technology, risks and issues)
  • Produce a business plan which shows how you anticipate covering all your costs, including your loan repayments and when you expect to have re-paid the loan

Plan Your Borrowing

At the end of the day Good Debts are still debts, which means that they need to be re-paid along with interest, so you still need to consider very carefully whether you can afford to take them out.

To help plan your borrowing, make sure you take the following steps:

  • Do your research to find the best deals – speak to your financial advisor, check the web or the ‘best-buy’ sections in the weekend papers for the lowest interest rates
  • Make sure you understand how much interest you will be paying throughout the lifecycle of the debt, whether there are penalties for early repayment and whether or not the debt is secured against your home – check the small print!
  • Create a budget to understand how much you spend & earn each month and check the repayment figures against your budget to ensure you can afford to repay the loan

Keeping Good Debts Under Control

Even when you have taken out a Good Debt, you should still try to minimise the amount you need to borrow and prevent the debt from running out of control.

For example, most people take out a student loan to pay for their university education.  In many cases this makes sound business sense if the degree will help them earn more money in the job market.

However those students who are able to pro-actively manage their finances, use money saving ideas to live frugally and find ways of earning a part-time income whilst they study; should be able to emerge from their studies with a far smaller debt to pay-off when they start working full-time.

The Good Debt Criteria

So if you are planning to borrow money, ask yourself:

  • What return-on-investment will this money provide and will it outweigh the amount borrowed (i.e. is it a Good Debt or a Bad Debt)?
  • Do you really need to borrow this much and what other options exist to make up the difference?
  • Will you be able to afford the monthly repayments?
  • Do you understand all of the conditions (interest amounts, early repayment clauses, etc) of borrowing the money?