Understanding the difference between good debt and bad debt will help you to avoid debt stressors on the road to pursuing wealth. YBI explains the difference.
Good debts are often used to build long-term wealth.
Bad debts tend to have no real value or are an asset that decreases in value.
As children, understanding the difference between needs and wants can be difficult. We need food to grow but we don’t want vegetables, we want to eat a donut. As adults we realise the donut will do nothing to assist our growth or abate our hunger but as a child we only desire the sweetness.
Much like the difference between good debt and bad debt.
Understanding the role desire plays can be the first step towards understanding the difference between good debt and bad debt and can help you make better decisions before you make the leap to go into debt.
Some people might say any debt is bad debt and this is also true. However, an adviser will explain that some debts are ‘better’ than others. So, what is the difference?
Good debts are often used to build long-term wealth. For example, the debt you go into when you secure a mortgage to buy a house or the HECS debt you pay to earn your degree could both be considered a good debt. Why? A home loan (provided you haven’t overpaid for the property and can afford to pay off the loan) is a good debt as it helps you build your wealth. A student loan allows you to get the qualifications you need to get the job you want to help you secure your future wealth… Good debts…
A bad debt would be a personal loan or the debt you get from a credit card when you have used the card or loan to buy day to day items, an expensive holiday or a luxury car. Bad debts tend to have no real value or are an asset that decreases in value.
Of course, on occasion you may acquire a bad debt for a good reason. Let’s say you get a new job and the only way to get to work is by car – your workplace is not accessible by public transport. Buying a car becomes a need rather than a want. But the type of car you buy could change the debt from a good debt to a bad debt. Buying a second-hand car within your budget is a good debt and fulfils a need. Swap this purchase to a luxury vehicle and suddenly you are veering into the realm of bad debt.
If you want to understand whether a purchase is good debt or bad debt, it’s important to ask these questions:
Will my purchase increase in value?
A house is likely to increase in value over time. A car will not.
Will it make me money?
Tools of trade that you need to do your job may cost you a lot – but will help you earn money in the future.
Does it save me money?
A new washing machine may cost you money but will save you from laundry bills. Here it’s important to remember a basic model will be good debt but one with all the bells and whistles will be bad debt as it will depreciate faster than it saves you money – so choose wisely.
It is also possible to make the most of good debt to repay bad debt. An example would be when someone rolls over their credit card balance to their home loan. This is sometimes called debt recycling, but it can be a risky venture as it moves what is often unsecured debt – like a credit card to a secured debt. Which means if you fail to make the payments your bank can take the secured property (in this case your home) to pay off what is owed.
Negative gearing is another example of using debt to increase your wealth. Negative gearing occurs when the interest and other expenses from an investment are greater than the income you receive from it. It’s a strategy often used by investment property owners and allows them to claim out of pocket expenses as a tax deduction.
As you can see, not all debt is the same. Bad debt should be avoided wherever possible but good debt can help you grow your wealth. Either way it’s also important to remember too much debt is never a good idea.