Understanding Debt: What are Good and Bad Debts?

The word "debt" scares most people off. Yet, not all debts are bad. In fact, sometimes it makes financial sense to be in debt. Confused? Here is a general guide about good debts and bad debts.

Really Bad Debts

In general, bad debts come with high interest rates, are easy to get, and encourage unnecessary spending. "It's the debt that's racked up using personal loans or credit cards to pay for things like groceries, clothes, entertainment, and holidays,” says Paul Clitheroe, top Australian personal finance adviser and author of Making Money. Borrowing money to buy such items with no lasting value can land people into deep financial problems. Clitheroe suggests immediately stopping unnecessary spending to manage bad debts. Have a financial budget and stick to it. Cut up credit cards and have a shopping list ready before buying anything. Live frugally for as long as it takes to repay the debts.

Bad but Essential Debts

Some debts are bad but sadly essential. All automobile and car loans fall under this "bad but essential" debt category. The value of a vehicle depreciates the moment it hits the road. Also, it costs money to run and maintain it. Fuel, car servicing, road tax, and car insurance are just some of the things that a car owner has to pay for regularly. Those with car loans should try to pay off the loan as soon as possible by depositing a bigger a down payment and increasing the amount of monthly repayment. Settle for a cheaper practical car instead of something sporty and expensive.

Good Debts

All good debts share the following traits: they are used to help something appreciate in value over time and generally come with a lower rate of interest. Examples of good debts are:

• Student loans. Student loans are considered good debts because they help finance a young person's education. A good education is a wise investment as it often guarantees better jobs with higher paychecks.

• Home loans or mortgages. Home loans and mortgages are good debts as well. Homes are assets that increase considerably over time. Very often, a house bought today has the potential to double or triple its value in the next 20 to 30 years, depending on the location.

• Business loans. Business loans can be used to start a business or expand an already established business. If the business is run successfully, the loan will eventually help increase profitability and improve services and products.

• Loans for investment property and shares. Property and shares are income-producing assets. However, loans for property and shares should only be taken out if bad debts have been paid off. Other things to consider include the possibility of rising interest rates and falling prices of property and shares.

There is nothing wrong to be in debt, but it is crucial to know what makes good or bad debts. Bad debts encourage people to spend beyond their means while good debts work towards what will become worthwhile assets in the future. That said, any debts, including good debts, can lead to financial disaster. So take out a loan wisely and ensure that repayments can be made promptly.