You will hear some high-profile personal finance experts say that all debt is bad debt, while others clearly separate good debt from bad debt with traditional adage (student loans and home loans are good debts; credit cards are bad debt).
The truth may lie somewhere in between. Debt can be a tool that can be viewed in good or not good ways. The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt. Here is how to know which is which:
Good debt is an investment that will grow in value or generate long-term income and there is no better example of the old adage “it takes money to make money”.
Mortgage or Buying a Home:
Taking out a mortgage or buying a home is usually considered good debt. Home mortgage generally have lower interests rates than other debt, plus that interest is tax deductible. Even though mortgages are long-term loans (20 years plus in most cases), those relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies. The ideal situation would be that your home increases in market value over time, enough to cancel out the interest you’ve paid over that same period.
Education has long been synonymous with success and the more education an individual has, the greater the person’s earning potential. Student loans typically have a very low interest rate compared to other types of debts and a varsity education increases your value as an employee and raises your potential future income.
A vehicle loan can also be viewed as good debt, particularly if the vehicle is essential to doing business. Unlike homes, cars lose value over time, so it is in the buyer’s best interest to pay as much as possible up front so as not to spend too much on high-interest monthly payments.
Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high interest rate, like credit card debt. The general rule to avoid bad debt is:
“If you can’t afford it and you don’t need it, don’t buy it.”
If you buy a fancy pair of R500 shoes on your credit card, but can’t pay the balance on your card for years, those shoes will eventually cost you over R550 –R600, and by then, those shoes will be out of style. When you take out your credit card, make sure your monthly payments don’t leave you strapped for cash each month (and results in new debt). You can make only minimum payments or pay little over the minimums; yours interest rates are high; you take a long time to pay off purchases, which means they are expensive over the long run.
Be careful not to buy non-durable goods on credit as you will be paying a higher interest rate. If you really need to use it, make sure you pay back the debt within the allocated time, as your costs of living will shoot up by paying more for your everyday basics.
Payday Loans or Cash Advance Loans:
These are some of the worst kinds of debt you can find. In a payday loan, the credit provider gives you the amount you want, plus a fee. Then you have until your next payday to pay back the loan amount, plus the original fee and any interest incurred over that time period. Interest rates for payday loans are astronomical, and if fail to pay back the amount b your next payday, you incur yet another processing fee to “roll over” the loan.
Clothing Store Accounts:
One of the most popular bad debts that younger people also have access to is store credits; this is another example of borrowing money at interest to buy things that don’t hold their value and end up disposable.
Now that you know the difference between good and bad debt, it is time to rebuild your credit history and stay on track.