While the word is intuitively negative, not all debt is created equally – and a little can sometimes be better than none. Here’s what you need to know.
Some types of debt are easily categorised – pay day loans are an example of bad debt; largely being added to a person’s financial deck of cards to pay off other debts, at much higher interest rates. Whereas refinancing to draw money to increase the value of your home before a resale would generally fall into good debt. In fact, it’s usually what the money being borrowed for, that best determines what type of debt you’re looking at – and your ability to pay it off.
Good debt is usually the type of debt that benefits you in the long term, ultimately making you money, says Greg Mawer from Mawer Consulting.
It is a loan to help grow your successful business that’s supported by a solid business case – example of good debt. Then there are the less obvious examples, such as HECS debt incurred by taking up higher education, ultimately scoring you a better paid job well into the future, with a zero interest ‘pay when you earn enough’ repayment terms.
Make the most of ‘good debt’ by carefully checking the terms and conditions of any loans you apply for: Does it have the best interest rate given your risk rating is lower? Are there penalties or fees for early discharge? Also ensure your debt stays good by having contingency plans in place should your circumstances change.
Conversely, bad debt is the type of debt that does not benefit you in the long term and goes towards paying for things that depreciate, says Mawer.
“Bad debt can come in many forms. Think putting your holiday on your credit card and not paying it off before interest kicks in. Or a personal loan for a fancy car that is not used for business,” he says.
Mawer says having bad debt which is paid off in a timely manner generally doesn’t impact you for the long term. But having bad debt which is not paid off in time can negatively impact your credit rating. Hindering your chances of obtaining a loan in the future.
Related Text: What is a credit score and how is it calculated?
‘Buy Now, Pay Later’ schemes – Afterpay or Zip-pay are forms of debt as it allow you to make a purchase you don’t have the funds for, paying it off in instalments over a short period of time. There is no interest or fees involved – you simply pay the instalments and the transaction is complete – making the credit ‘neutral’.
Nonetheless there are downfalls to these schemes becoming bad debts. By not paying off the amount in time it affects your credit rating. Also if you’re making instalment payments using your credit card and not paying off your cards in time, you’re essentially racking up debt for an item outside your means.
Along these lines, credit cards are another grey area, erring on the side of bad. In our debt driven society, it is seen as acceptable to get a credit card and repay it on time, to show the bank when you want to borrow hundreds of thousands of dollars, that you are reliable, trustworthy and will repay the loan, Mawer says. This is fine in theory, but Mawer says where people get into trouble with money is not the numbers, it is mindset.
However, using a credit card to make transactions, then paying them off in full every month is a good debt, considering your line of credit as available funds you ‘own’ is quite the opposite.
Obviously necessary to most Australian’s buying a home and coming with a lower interest rate than personal loans or credit cards, taking on a mortgage is a good debt in terms of helping you build personal wealth. However, it can become a bad debt if circumstances change and you haven’t planned. Before taking one on, consider how you would make repayments if the property market drops out, interest rates rise (while they are at a historic low now, bear in mind Aussie mortgage rates have sat as high as 18% in the past, and the average term of a mortgage is 30 years) or you lose your job.
You should generally have at least 20% equity in a property investment. This way, you don’t have to pay the bank lenders mortgage insurance, which can be very expensive and only protects the bank if you default, not you, Mawer says.
So in short, when determining good versus bad debt, ask yourself – is going into debt going to pay dividends, or simply create a liability you’re going to be paying off well after you stop enjoying whatever you spent the cash on?
Words by Melanie Hearse
Whether you’re on the lookout for your first home or wanting to refinance, eChoice can help. With access to 100s of home loan products and over 25 lenders, eChoice brokers have everything they need to find you the best deal.