Over the years, debt has gotten a pretty bad rap – and often for good reason. But it’s important to remember that not all types of debt should be painted with the same brush, and that there is such a thing as good debt.
Knowing the difference between good and bad debt is crucial to wealth creation. Everyone will be in some degree of debt at some point, but getting caught up in the wrong types of debt can have serious consequences on your ability to save for the future.
Generally, debt can be split into three broad categories: ‘the good’, ‘the bad’, and ‘the ugly’.
Good debt is debt which can help you earn money if you stay disciplined. The most common forms of good debt are student loans, mortgages and small business loans, which all essentially provide finance for something you can’t afford right away, but can increase your future earning ability or capacity to finance appreciating assets.
This type of debt can also be tax-deductible, which means that for tax purposes, you can offset the interest cost of your debt against the income generated from the asset.
But even good debt has its risks. Even with good debt, the quicker you manage to pay it off; the better. In this sense, a mortgage where you have access to your money can be problematic.
If you regularly use the access fund on a short-term basis, you can spend twenty years paying off your original mortgage amount because you only paid the minimum interest on your loan and didn’t fast track the repayment of the borrowed capital.
Short-term debt is generally bad debt as it prevents you from saving. This can be any debt that you incur when buying clothes, furniture or accessories, and also applies to money borrowed to pay for events like a wedding or birthday party.
The interest on purchases with your overdraft facility or credit card is extremely high, so you can expect to pay more than double at times. If you feel that these purchases are absolutely necessary, rather delay your gratification and save up for them and you’ll probably enjoy them more.
Buying a car on credit is also not the best debt to acquire, as it is not a growing asset. On the contrary, the value of a vehicle depreciates the moment you drive it off the showroom floor.
If you have to buy a car, to make your life easier or get to work, try to at least make a down payment in order to reduce the amount of credit required and remember that you still have to pay for insurance, tyres, services and fuel.
Within most financial circles, ugly debt refers to micro- and payday-loans, as well as any form of unregulated credit.
Before you sign an offer, ask yourself why your bank can’t offer you the same. Microloans have incredibly high interest rates, and you could repay four or five times the value of your original loan, which can quickly form a vicious financial cycle, commonly referred to as a ‘debt trap’.
To break free from this cycle and start saving, I suggest having a strategy. The very first thing you need to do is pay off your ugly and bad debts, before you can even start thinking about saving. Budget, evaluate and consolidate.
Trim down unnecessary expenses to repay your debt, find out how much interest you pay on your loans, and transfer high-interest debt to lower-interest facilities, so you can make more money available to repay your loans faster.
From this point, you can set yourself a goal towards paying off your good debt, while simultaneously reaping the benefits of that good debt and saving towards your future.