Friday, 19 June 2015

Good Debt vs. Bad Debt

In the world of personal finance, there are 3 types of debt: Good, Bad, Ugly. While there are some who would argue that no debt is good debt, I beg to disagree.

The Good...

It is fairly straightforward to distinguish good debts. These usually combine several different beneficial features such as:
  • Low interest rates
  • Excellent repayment terms
  • Little to no prepayment penalties
When you are able use these benefits to your advantage, debt can become quite productive and even work for you. A mortgage can often be considered good debt, as they usually come with competitive rates and terms, and allow you to invest earlier in an asset(your home) that will likely hold or even increase it's value over the life of the loan.

Another use of credit like this might be to fund an education, for example. If you are able to secure a student loan with a good interest rate and terms, you can use that money as an investment in your future earning potential. It is important to remember that how you utilize the credit you have available to you is the key to carrying 'good' debts.

If you consider how much the debt will cost you overall and compare that to the benefit of what you are purchasing or investing in, you will be able to make a decision on whether that debt is 'good' for you or not.

The Bad...

Most of us are aware of the 'bad' debts we have had or currently have. These usually encompass credit cards or personal debts which have high interest rates and sometimes challenging repayment schedules or penalties.

One of the key defining features of 'bad' debt is that the debt is built through purchases of goods which do not hold or increase in value. Prime examples might be consumer goods like electronics, furniture, etc. As soon as you have bought the item it's value begins to diminish, despite the interest which is already accumulating behind the scenes. That couch you bought for $1000 today might well wind up costing $2000 by the time you add in interest and any fees associated with your financing. The worst part of all is you now have a $1000 couch(which you essentially paid $2000 for), which is actually worth far less than even your initial purchase price.

When you think about all the costs associated with credit-funded purchases like this, it's easy to see how these debts can grow very quickly to become overwhelming and out of control. It is important to work to pay these debts off quickly to minimize the effects of compounding interest and depreciation of your assets.

The Ugly...

While I could just as easily lump this category in with 'bad' debts, I like to make a distinction between
average credit cards/loans and department store cards, payday loans, and other 'point-of-purchase' financing programs. It's tempting to make purchases on these types of readily-available credit programs, but the costs can escalate quickly.

Financing like this usually comes at extremely high interest rates(think 20%+) and may even include hidden or up-front fees. Even if the interest rate seems reasonable(no interest for 90 days, etc.), make sure that you include the cost of the fees when calculating the cost of these options. When you include their so-called 'administrative fees' these cards and loans can often cost in excess of 30% or more!

When was the last time you took a look at your debts and thought about which were good, bad, or ugly? It's a review I recommend on a twice-yearly basis for my clients in order to keep on top of things and make use of their existing credit in as effective a manner as possible.

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