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How to Tell the Difference Between Good Debt and Bad Debt

Growing up, you learn quickly that credit can grant you what cash doesn’t. Applying for credit to buy a property or a car, thus incurring debt, becomes an accepted part of life.

But, while having debt is expected to fulfil ambitions, few understand the distinction between good debt and bad debt. Knowing this can help today’s youth and future generations avoid too much debt and the financial troubles it brings.

What is good debt?

Good debt represents a loan used to finance credit that offers a positive return on the investment, such as increasing your income or net worth.

Examples of good debt include secured debt guaranteed by collateral, which translates into lower interest rates. Generally, any low-interest debt that increases your income or net worth is good debt, such as:

  • Property loan or mortgage. Buying a home is good debt when the property increases in value or generates income by the time the loan is paid off.
  • Student loan. Generally, applying for finance to access higher education is recommended if it furthers studies and helps you secure a better-paid job upon finishing the degree.
  • Business loan. Any borrowed money that helps you start a business or improve business prospects to generate more income is good debt.
  • Vehicle finance. A car loan is considered good debt when the vehicle is necessary for daily needs such as transport to work to earn an income. However, too much vehicle debt can be detrimental to your finances and become bad debt, as seen below.

What is bad debt?

Examples of bad debt include any consumer debt that is of no lasting value and does nothing to improve your financial situation. This type of unsecured debt has no collateral backing and is given based on creditworthiness and at high-interest rates, such as:

  • Credit card debt. This is the most common type of bad debt. Incurring debt for everyday expenses without a goal in mind or a plan to manage it is seen as bad debt.
  • Retail store accounts. This consumer debt, e.g. clothing accounts, is the easiest to come by and can pile up dangerously fast if not controlled. In addition, multiple accounts with high outstanding balances impact your credit score negatively.
  • Personal loans. Any credit offered for personal use at a high interest rate is generally bad debt unless used or invested for educational, business growth or other income-generating assets purchases.

While consumer debt is viewed as bad debt, it can still be beneficial only when used responsibly or in case of emergencies, as long as the instalments are paid monthly without fail.

It is essential to know that banks, financial institutions and creditors list as bad debt any accounts in arrears with regularly missed payments or gross mismanagement. Since this bad debt adversely impacts the credit score, keeping it to a minimum is critical.

Too much bad debt?

Too much debt, even while it is good debt obtained at a low interest rate, can become a burden and turn rapidly into bad debt if not managed properly.

Without a debt management plan, doing so can lead to an unsustainable lifestyle, not to mention the improbability of total repayments. A credit card may be a helpful tool, but if you rack up credit and only pay the minimum, then max out your card again, you are entering a vicious cycle of bad debt.

Before financing any new purchase, ask yourself if it adds value to your lifestyle and how it impacts your current debt repayment plan. For example, a vehicle loan may seem like a good idea at the time, but it can also turn into bad debt if it puts your finances under pressure and you are struggling to make the repayments.

A common trend amongst the South African youth is to borrow too much for important goals such as high education, a car or their first home. Unfortunately, this attitude will carry on later in their lives, leading to over-indebtedness and possibly financial ruin.

This is why understanding the difference between good debt and bad debt from an early age is the first step to avoiding more unnecessary credit. It can stop the habit of incurring further debt you can’t afford to repay, realistically.

For this purpose, it is helpful to enlist a debt counsellor’s service to assess your debt habits and reduce massive bad debt to a safer threshold. A debt review process may be necessary to rethink a more affordable repayment plan, reducing multiple repayments into a lower monthly instalment. Your debt counsellor can negotiate with creditors on your behalf to minimise all bad debt. For more information, consult an ezDebt adviser.

Our professional ezDebt advisers can help you stay on track with debt repayments through a quick and affordable debt review. All our debt counsellors are registered with the National Credit Regulator (NCR). Get in touch at www.ezdebt.co.za.

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