Good and Bad Debt

The topic of debt is one of the important topics in personal finance. It is a topic we cannot avoid because it affects a lot of people. On one side are people who have wrecked their finances by taking on loads of bad debts. On the other side are those who, as a result, believe that any kind of debt is bad. There are some good debts and some bad debts, though there are lots of qualifications in between. Generally, when it comes to incurring debt, it is better to be on the side of caution.

[bctt tweet= ” Generally, when it comes to incurring debt, it is better to be on the side of caution.”]

Good Debt

Good debts are debts incurred to purchase assets that will provide a value that outweighs the cost of incurring the debt. These investments will grow in value or generate revenue into the foreseeable future. For example, financing a debt at 10% interest rate to purchase an asset that pays a 20% APR for the same period makes financial sense.

[bctt tweet= ” Good debts are debts incurred to purchase assets that will provide a value that outweighs the cost of incurring the debt. These investments will grow in value or generate revenue into the foreseeable future.”]

So while it is generally better to avoid debt, there are good debts that provide value. Below are some examples:

Mortgages

There are instances where it is better to rent a home than owning one. But when you decide to own a home, taking a mortgage to finance the purchase of your home is generally a good debt.

Interest rates on mortgage are generally low, and the period of repayment generally long. As a result, monthly repayment is lower than what you would pay as rent if you rent a home. The advantage here is that you can invest the extra amount (rent-mortgage payment) in assets that yield interest rates that are higher than the rates on your mortgage payment.

Furthermore, the homes tend to increase in value over time. The rate of increase in the value of your home can far exceed the interest rate on your mortgage. Also, the interest you pay on mortgages is tax-deductible.

So taking up a mortgage to buy a home is generally a good debt. Ensure you explore and find low rates. It is also advisable to keep the years on mortgage between fifteen and twenty years and make down payments up to 20% the value of the home.

Student Loan

Obtaining loans to attend college is generally a good decision. The expectation is that education will improve your skills and prepare you to earn a higher income. In the long run, we expect higher levels of income to have more value than the debt. Likewise, student loans generally have lower interest rates than other typical loans.

Your student debt should not exceed your expected first-year salary (others use 1.5 times expected first-year salary). Many financial experts also advise that you consider other funding opportunities before taking up student loans. Some of those options will include all forms of scholarships and grants.

A student will also have to choose a course with a clear career path and good earning potential.

Business Loan

Incurring debt to finance business investments is a good idea. The expectation is that the increase in revenue from such investments (over several years or perpetual) will pay off the cost (principal and interest). Businesses don’t grow just on retained earnings. It is often important to borrow money for growth and expansion.

However, it is important to ensure the profitability of such investments using calculations like NPV (net present value) and IRR (internal rate of return). There must be realistic expectations and a critical look at the condition of the business and its ability to finance such a debt.

Home equity loan

Home equity loan is a loan you get on the equity value of your home. With home equity loans, your home serves as the collateral. Home equity is the difference between the fair value of your home and the outstanding debt on the home. That amount constitutes a collateral which loan providers will evaluate to give you a loan.

The reason why they can be a good debt is the low-interest rates. What you do with the money will also determine if it ends up as a good debt or a bad debt. It is important to avoid home equity loans with variable interest rates and to explore various deals before deciding on one.

Thinking through

While people consider the debts above as good debts, it is not an absolute designation. As discussed, some factors come into play that determine if they are good or bad. A good student loan for one student may be a bad student loan for another. A business might be in a good position to take a loan while it may spell disaster for another. A mortgage deal can become bad if you take more than you can afford or can’t pay a good percentage down on the mortgage value.

There are other types of loan that can turn out to be good debt.

Loan consolidation is an example. You consolidate a loan when you exchange a higher interest loan for a lower interest loan. There are situations where such consolidation is possible. Loan consolidation helps you to pay off debt quickly or reduce the amount of debt repayment for the same period.

Borrowing to invest in stocks or real estate (leveraging) can also be a good debt. There is a risk involved, but if done successfully, it is a good debt that pays more return than the interest rate on the debt. It is a strategy that someone like Robert Kiyosaki uses.

Bad Debt

Bad debts are debts that can wreck a lot of havoc on your financial life. They tend to be high-interest debts used to purchase items that decline in value or consumable items. Bad debts occur when you take up a significant rate of interest on things that will not add any value in the long term. Bad debts are often a result of poor financial planning. Below are some examples:

[bctt tweet= ” Bad debts occur when you take up a significant rate of interest on things that will not add any value in the long term. Bad debts are often a result of poor financial planning.”]

Payday loans

A payday loan is a type of loan where you borrow money pending your payday. Your payday is the day you receive your salary. So a payday loan is generally within the 30 days window. They often come with high fees and interest rates, with APR of up to 400%. In case of default, you pay extra processing fees to rollover the loan amount to the next payday. Many people use payday loans to meet emergencies.

Car loans

A car begins to reduce in value from the moment you drive it home. Paying interest rates when the car does not add any significant value makes it a bad debt. A car loan can be a good debt if you use it for business, or it saves you a significant transport cost. In the absence of those two conditions, it is often a bad debt.

It is better to buy a reliable (not one where the marginal cost of maintenance will exceed the interest rate on a new car) used or old car (older models) you can afford or look for ways to finance a car purchase with little or no interest.

Credit Cards

Credit cards are the worst. The interest rate is so high, and the whole arrangement has the intention of making you pay as much as possible. They are more expensive than consumer loans. APR can reach up to 30%. Paying only the minimum balance is bad, defaulting on payment is even worse.

Most of what people use credit cards to pay for are consumable items and items that don’t increase in value.

There are credit cards with cheaper interest rates, and there are credit cards with reward programs. In this case, the money you spend with credit cards can help you earn free airline tickets, bonuses, cashback, among other benefits. It can be a good option to explore if you pay off the balance on your credit card at the end of every month.

Other Consumer Loans

These are loans people take to meet household needs. Consumer loans have high-interest rates, and most people use them to purchase items that don’t increase in value – consumables.

How to Avoid Bad Debt

The best way to deal with bad debts is to avoid them – to be in a position where you don’t need them. There are several ways to be in this position:

Have a budget and stick to it

We can avoid many of the situations that make us incur bad debt with good budgeting techniques. With a budget, you know your expected income and expected expenses which makes it easier to avoid impulsive and unnecessary purchases. A lot of the emergencies we decry will not even arise if we paid attention to proper budgeting.

[bctt tweet= ” We can avoid many of the situations that make us incur bad debt with good budgeting techniques”]

Have an emergency fund

But some emergencies are “actual” emergencies. This is why it is important to keep an emergency fund. An emergency fund is a fund set apart to cater for emergencies, so you don’t need to incur debt to meet such emergencies. The idea is to keep money in a place where it generates interest and is easily accessible. The size of your emergency fund will differ based on personal circumstances. But it can be between one to six months of your monthly expenses.

[bctt tweet= ” An emergency fund is a fund set apart to cater for emergencies, so you don’t need to incur debt to meet such emergencies”]

Save and Invest

When you save and invest, you will have money stored up to buy the things you desire without debt. Investing money in profitable investments is a good personal finance habit

What to do with Bad Debt

Is there still hope if you are already in the pool of debt? Well, there is hope. But it is a kind of hope that comes with sacrifice.

To get out of bad debt, you must first have the conviction that bad debt is “bad.” Second, you must have the desire to get out of it.

[bctt tweet= ” To get out of bad debt, you must first have the conviction that bad debt is “bad.” Second, you must have the desire to get out of it. “]

Think of all you could do with the money you have spent paying back huge interests. Think of how much interest you could earn on those amounts. What about all the emotional aches that come with debt?

It is when you think that a life without bad debts is better that you can begin to take some steps towards freedom. In the book, “Personal Finance Simplified” by Tycho Press, we have these five steps to freedom from bad debt:

• Stop borrowing money: There is no point trying to get out of debt and then go ahead to borrow more money. It is counterintuitive.
• Cover all your necessary expenses first: Getting out of debt does not mean you can ignore your living expenses. Ensure you cover your housing, food, clothing, and transport expenses (and other expenses in the “necessary” category) but not more. This is time to be frugal.
• Don’t tap your emergency fund: In case you already have an emergency fund, never tap into it to pay off debt. Emergency funds are for emergencies, not debt repayment. If you use emergency funds to pay debt, when emergencies come, you will incur those debts again.
• Start your debt snowball moving: Write out all your bad debts in a sheet with a column for amount owed, interest rate charged, and minimum payment. Start with the debt you can easily pay off to get some momentum.

To carry out this process, you need a surplus, and you need to ensure the amount you currently apply towards payoff will continue to serve that purpose until you have cleared the account. The surplus is an amount you can pay above the minimum payment of your debts. You can get the surplus by ensuring that it is only your necessary expenses you are incurring every month.

Start with the smallest debt, pay the minimum balance, and then use the surplus to pay the debt. It is good if the debt is paid off by the surplus. If the surplus remains after you pay off that particular debt, apply it to the next debt.

As you pay off one debt, you move to the next debt with that surplus amount, and then the next.

• Revel in the success, then repeat it: As you clear off the lower amounts, use the momentum to go to the higher amounts until you pay off all the debts. Celebrate the little victories, but don’t over celebrate with something expensive. In a few months (depending on your debt size), you should be completely free from debt. Then go back to read the section on how to avoid bad debts in the first place.

Conclusion

Understanding the difference between good and bad debt is important to your finance. It is also important to know how to avoid bad debts and how to be free from bad debts. When it comes to debts, it is always good to be on the side of caution. To do this requires a great deal of self-control and forward-thinking.

[bctt tweet= ” When it comes to debts, it is always good to be on the side of caution. To do this requires a great deal of self-control and forward-thinking.”]