I used to live my life thinking that being completely debt-free is a wonderful thing. This is because there is a period of my life that I am in debt. I felt that those debts are heavy burden. Therefore, I decided that having debts is a completely bad thing and I pushed myself very hard to repay every single cent of it.
This resulted for a period of my life, I am living completely debt-free. While I felt very light during that period, it is not a smart thing to do. I realise now that I am liability free but not financially free (see the article on financially free vs liability free). I noticed people around me having debts, yet they are doing financially better. Why is it so?
I then understand there is a difference between having a good debt and a bad debt. The debts that I used to carry are the bad debts. Therefore, it is appropriate for me to clear them as soon as possible. However, I have missed out taking on good debts. By taking on a good debt, it can help my financial future.
So, what is a good debt and what is a bad debt?
This is my definition:
“A good debt can benefit and gives leverage to your financial future, while a bad debt will harm your financial future.”
So, what exactly is a good debt? One example of a good debt is property mortgage loan. By taking up a mortgage loan to purchase a property, you don’t have to fork out the full sum to pay for property. We use the debt as a leverage to get better returns.
For example, if the property appreciates by 20% and your down payment is only 20%, your returns is 100% (before cost). If the borrowing or interest cost is only 2%, then it really makes sense to take on the loan. In this scenario, this debt can benefit your financial future, thus it is a good debt to take on.
Another aspect of a good debt is the ability of the person to repay the debt fully. With the same example above, if I have the financial ability as well as a realistic plan to repay the mortgage loan, then I would consider it a good debt. However, if I take up this similar debt without any ability to repay it, or I have stretched my finances in order to pay back this debt, then I will consider it to be a bad debt. Here, we see that we cannot generalize on which kind of debt is good. It will depend on the financial situation of the person taking it.
Besides mortgage loan, another form of good debt could be in the form of “personal investment”. For example, taking out a student loan to obtain a university education. With the education, I can increase my value as an employee and raise my potential future income. However, if I took up this study loan just to get another certificate and not using what I have learned to add value to my future career, then the money will be wasted. I will deem this student loan as a bad debt to take on.
Business loan which allow you to start and grow a profitable company is also a form of good debt. So just remember, if the debt you have taken on can benefit your financial future, and if you have a realistic plan of repaying it, then it can be considered as a good debt.
If the debt won’t bring you better financial future or future income, it is a bad debt. Bad debt is incurred when you buy things that will lose their value over time. You may feel good the moment you took up the debt. Soon after that, you will get a feeling that the debt chains you up as there are no possible financial returns from the debt or no way you can repay it soon. So, bad debt will usually satisfy your current lifestyle but ruin your financial future.
One other typical trait of a bad debt is that it carries high interest cost. For example, if you buy a fancy $1,000 pair of shoes on your credit card but you cannot pay the balance on your card a year. This pair of shoes will eventually cost you over $1,240 (24% interest per year).
Don’t get me wrong here. It is alright to make purchases on your credit card if you can pay them off every month before the interest accrues. But if you have the habit of buying things that you cannot pay off; it is going to cost you much more money to get out of it. So, if you cannot pay off the debt, it is probably better not to spend it.
Other examples of bad debts are, a luxury holiday you can’t afford, a fancy car that you do not need or borrowing money from finance companies that charges high interest rates.
How about car loan?
New cars almost always lose their value the moment you drive out of the showroom. Worse, if you cannot keep up the monthly repayments, you may end up having a loan that is more than what the car could sell for. Imagine having no car now but a debt to pay for!
However, if the car loan is use for business purposes, whereby the car can potentially make money for the business, the car loan may be considered as a good debt.
We cannot generalize on which kind of debt is good and which kind is bad. It will depends on the objectives and the financial situation of the person taking it. In general, I will try to maximize taking up good debt and minimize bad debt.
Note that sometimes too much of a good thing can become bad. You can be over leveraged in your property loan and resulting in defaulting it. Therefore, before taking on any debt, be sure to think thoroughly on how it will impact you and your financial future.
Do also read up on Debt ratio to have a better understanding on how much debt you should take on.