Understanding good debt & bad debt and the difference
Is all debt bad debt? This is one of the age-old questions that have been asked for generations. After all, owing money to a bank or financial institution can’t be a good thing, can it? Isn’t it bad to be in debt in the first place? After all, we have all heard the saying, “All debt is bad debt”.
However, the truth is far more nuanced than this. Now is a better time than any to understand debt – both good and bad.
Debt can be good if it helps you grow your finances in the long run without affecting your ability to pay back the principal amount with interest.
However, one needs to take excessive care and precautions when it comes to taking out debt – because it can either lead you to become extremely successful or drive you down a path of bankruptcy.
With this in mind, we take a look at the differences between good and bad debt, and some examples of each to shed light on the topic beyond doubt. First, good debt.
To keep it simple, good debt leaves you better off than before you borrowed the amount. It often leads you down a path of prosperity and growth. There are many purposes one might take out debt that could eventually turn out to be positive for the borrower. For better clarity, let’s look at some examples of good debt –
- To Start a Business – To be clear, not all debt taken out to start or grow a business is good debt. If one takes out a business loan and the business ends up failing or closing down, it may well be considered bad debt. With regards to business, debt can be considered good if it helps the borrower establish or grow a successful business that brings financial freedom and allows him/her to pay back the loan easily.
- To Buy a House – Everyone needs a house to live in. If the borrower takes out a loan to buy a house that ends up appreciating over time, such that the valuation is more than the debt that was originally borrowed, this may well be considered good debt.
- Student Loans – A better education often unlocks the doors to superior, higher-paying jobs. If you’ve gone ahead and taken out a student loan that improves your skills, and eventually brings you success in your career, this can be considered good debt.
Bad debt can ruin one’s financial position and leave one struggling to pay it off. The main reason for this is that it doesn’t help you generate more income. Here are some examples of bad debt –
- Consumables – Some of the best examples of bad debt can be car/bike loans. While there’s nothing wrong with having a car or a bike as a means of transport, the issue begins with the fact that it is unlikely to bring you more income. Vehicles depreciate with time, meaning they are worth less than what you paid for them. Considering that the borrower also owes interest along with the principal, taking out loans for vehicles can become money pits quickly.
- Trips & Holidays – It is always said that trips and holidays shouldn’t be bought on a credit card, and there is a good reason for this. Many families today still struggle with paying off holidays they went on years ago, and it’s no surprise. Unless the purpose of the trip could bring you more income, you’re likely to be put in a position of difficulty paying it off over the long term.
How does one know if the debt is good or bad?
In short, good debt has the potential to earn you significant returns over the long term. For example, taking out debt to start a business that later goes on to be successful can be considered to be good debt.
The reason is, taking out the debt has brought you to a much better financial standing than you were in before.
Bad debt is often taken out to fund depreciating liabilities, that don’t earn you any income. These are often harder to pay back and do not leave you in a better financial position than you once were.
So as it is clear, the difference between good debt and bad debt is the financial position it puts the borrower in. Loans taken out for consumables that depreciate over time are often bad debts.
Debt taken out to produce income and add value to the economy is often considered to be good debt.
What are some examples of good debt?
Some examples of good debt are student loans for higher education, mortgage loans to purchase a primary residence, business loans to finance expansion or growth, and loans for investments in income-generating assets such as rental property.
What are some examples of bad debt?
Some examples of good debt are credit card debt for consumables, personal loans for depreciating assets or luxury items, auto loans, etc.
How do you know if a debt is bad?
There are various factors to consider before you decide for a debt to be bad. If the debt – doesn’t increase in value over time; has high-interest rates; doesn’t generate income; finances a depreciating asset (like a car), etc, then it can be considered bad debt.