Whilst for most it's almost impossible to live debt free today, understanding the difference between good debt and bad debt will enable you to borrow smarter, save substantial interest costs and grow your wealth.
One of the secrets of borrowing money is knowing the difference between good and bad debt. Some people regard owing any amount of money as bad, whilst others enjoy a life long passion for borrowing. The amount we borrow is important, but what we buy with the money and the type of loans we choose can have an even bigger impact.
When used appropriately, debt can greatly assist business growth and help build your personal wealth. But when the wrong types of debt are used, the opposite can also be true. So how can you tell the difference between good debt and bad debt? Here is a straightforward guide:
Good debt
In general terms, good debt creates wealth for you. There are several types of loans that can be included in this category:
- Real estate: Undoubtedly the most common example, real estate loans fund the purchase of millions of homes and business premises. Two things make these loans good. Firstly the real estate purchased will still be around long after the loan has been repaid. Secondly, the long term increases in value of the real estate typically outweighs the interest costs. Borrowing to purchase real estate gives you or your business a place to reside. Alternatively, if rented out it can provide income and tax deductions.
- Investment: Loans to purchase sound investment such as quality shares or managed funds are typically good debts. The returns on those investments are usually above the loan costs, which are also usually tax deductible.
- Business: Loans to fund your business such as a term loans, inventory finance or leasing all help your business grow through the provision of more capital, increasing turnover and generating more profits. To do this, the loan term should be no more than the expected life of the asset purchased, ensuring revenue for servicing the debt is available over the term of the loan.
- Consolidation: If you're currently paying high interest rates on credit cards, store cards and personal loans, refinancing these into one consolidated loan at a lower rate could save you significant amounts of interest. Also, by paying this off over a few years, you get rid of those hard to pay off cards.
Bad debt
When we borrow to buy something that goes down in value and doesn't produce income, it's bad debt. Bad debt often creates pleasure, but not wealth.
- Credit cards: Most credit cards and store cards are used to purchase disposable or depreciating items such as meals, vacations and clothes. Whilst credit cards offer a convenient method of payment and access to emergency funds, few of us are disciplined enough to pay off the entire balance before the due date, thus incurring high interest charges which continue long after the purchase is forgotten.
- Overdrafts: When used correctly, overdrafts are good debt used to cover peaks in working capital and then repaid, generating additional growth and revenue for your business. However, the overdrafts of many businesses are almost permanently drawn to their limit and are an expensive way to fund long term debt. If the overdraft is still outstanding long after the items purchased are used, then it's bad debt.
- Personal loans: Whether it's for a car, boat or holiday, personal loans are rarely good debt. Whilst they usually generate substantial pleasure, the items purchased don't produce income and rarely increase in value. If you do take out a personal loan because of lifestyle choices, make sure that the debt doesn't outlive what you've purchased.
If you do have any bad types of debt, focus on paying off the highest interest loans first such as store credit cards, whilst making the minimum payments on any other debts. When you've repaid each one, continue to work your way down to the next highest interest loan.