What’s the difference between good and bad debt?

Money | Personal Finance

Know the difference between good and bad debt. Building good debt is crucial for your credit profile and home loans. You’ll need a proper budget and be smart with your credit cards.

For some debt is a dirty word, but for most of us, it is inevitable and often necessary. Caution is the watch word here – because not all debt is created equal.

So, what is the difference between good and bad debt? Good debt is investing in anything that increases your current or future net asset value, like buying a property. Bad debt is usually a high-interest spend on something that will rapidly depreciate in value – like a new HD television.

Good debt can help you achieve your life aspirations and career ambitions. Bad debt can leave you in a financial crisis with a poor credit profile.

Your future and your credit profile

A good credit profile is essential to being able to secure financing – now and in the future. When you’re starting out, you may find it a challenge to build a credit profile when you have not made much debt. Some banks will use scorecards and credit bureau reports to decide if you qualify for a credit card, personal loan or asset financing.

But that can be a narrow-minded view. As a professional starting on a career path, you are often your own best asset, and a credit provider should take a view on your professional potential and future earnings when assessing risk.

Home, sweet home (loan)

Buying a house is a good debt and an important milestone in your life and credit journey. In fact, you could see this step as a forced saving.

If you’re a potential homeowner, shop around for the lowest interest rate when buying or building a property. While a low rate is important, it should not be the only consideration. Buying a home or property is a complex transaction and involves multiple parties.

From registration fees to valuation costs, find out exactly what the loan will cost you and look out for hidden or unforeseen fees. Where fees are unavoidable, investigate how you can capitalise these into your credit facility – in other words, how they can be added into your principal debt. A home loan is probably the biggest amount you will borrow, so it should be as customised as any other personal loan.

Be smart with plastic

Credit cards are often the culprits when it comes to bad debt. Always check interest rates and look for any hidden costs. Understand exactly what you are paying for, what you are getting in return and what the trade-offs are for you.

Some credit cards charge higher interest rates than others do – often above the prime rate. Store cards often come with an even high interest rate, simply for the convenience of buying on credit at your favourite retailer.

Budget before you binge

To avoid living off your credit card until the next payday, plan ahead. Draw up a budget and try to stick to it as much as possible. A budgeting tool or app can make it easier to get a complete picture of your finances.

Your attitude towards debt is probably what will determine your credit future. Instead of seeing it as burden, view it as an investment that you have control over. For example, pay off your home loan quicker than the loan term if possible. A performance bonus or tax refund is just the type of windfall that can reduce the capital you owe on your property. Not only is this a ‘win-win’ in investing in a future asset, but it will also ensure stability in lean times.

Debt can be an emotional subject and rather than seeing it as black or white, good or bad, view it in context of your own lifestyle and needs.

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5 thoughts on “What’s the difference between good and bad debt?

  1. What an insightful post I was hoping to read more. My husband and I we are planning on buying a house and we’ve come to learn of the need to build a good credit profile and as such we appreciate posts like these.

  2. Some people believe a store card should be avoided at all cost however if you have a 6 month interest free clothing account why would one, one to use any other facility to pay for i.e training clothes or new bedding. Why should you use your savings if you can earn interest on your savings in your current account that you would have spent on clothing necessities. What is your opinion regarding this.

  3. If you’re paying off your store credit in the interest-free period, that should be fine. But, guard against falling into a debt trap where you open too many credit products and can’t pay these – or have to pay at a higher interest rate.

  4. You can build a good credit score after making just a few timeous payments on a credit product. The challenge is to not create a bad credit score by missing payments or paying late. If you have got yourself into a late or non-payment cycle, restoring your credit will depend of the amount of debt, time in arrears and other factors. Look out for our new blog on creating a good credit score.

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