Good Debt Vs Bad Debt

Often financial gurus talk about ‘good debt’ and ‘bad debt’.

Bad Debt - Bad debt is when a loan has been used to buy goods / services that reduce in value. Below are some examples of Bad Debt

• using a personal loan to go on an overseas holiday
• using a car loan to buy a car
• using the credit card to update your wardrobe

Good Debt - Good debt is when a loan has been used to purchase goods / services that grow in value. Below are some examples of Good Debt:

• using a home loan to buy an investment property
• using a personal loan to buy some shares
• using an investment loan to buy into a managed fund

Bad Debt

There are a number of issues that surround bad debt:

• Generally the items you are purchasing lose their value over time:
  
  • your car will depreciate
  • your clothes will go out of fashion
  • your latest gadget will become outdated
• You end up paying a lot more for the item than the purchase price as you have to pay interest on the item:
  
  • $5000 holiday purchased on a personal loan could cost you $7800 as interest on this debt over seven years amounts to approximately $2800 based on 13.5% interest
  • $1500 TV purchased on a credit card could cost you over $2000 as interest on this debt over three years amounts to approximately $500 based on 18.9% interest
  • new kitchen of $17000 purchased on a personal loan could cost you $24400 as interest on this debt over six years amounts to approximately $7400 based on 12.8% interest

However there are certain circumstances where bad debt can’t be avoided:

• Major renovation or car expense that ends up on the credit card
• Unexpected hospital expense paid for by personal loan
• Helping a family member out of a major circumstance by paying their expenses on your credit card

As you can see bad debt can get you through those unavoidable situations and the priority should always be given to clearing these debts as soon as possible.

Good Debt

There are a number of benefits with good debt:

• Generally the items you purchase increase in value over time which can compensate for the interest you pay on the loan:
  
  • Your share investment will rise in capital value
  • Your investment in rental properties will increase
• Generally by borrowing money it allows you to purchase major investments that you would not be able to save for in the short to medium term:
  
  • Bob needed $400,000 to buy his first investment property. To save $400,000 it would take Bob years and even decades, plus by the time he saves this amount, it is likely his $400,000 would not buy him the same property in the future. However if Bob saved a deposit and then got a loan to cover the remaining purchase amount, it may take him only a few years to get started with a property portfolio.
• There could be some tax advantages of borrowing money for investment or business purposes by claiming:
  
  • loan interest
  • loan establishment charges
  • on going loan service fees

Which Debt Should Get Paid Off First?

At the end of the day, whether its good or bad debt, it means you owe money to somebody else that will need to be repaid in the future. Having read the explanations of these debts above, you will realise that it is wise to pay your bad debt off first, and then concentrate on clearing your good debt.