What is the difference between good debt vs bad debt?
It might seem unexpected to say that there is such a thing as good debt. Before we look at what makes some debt good and some debt bad, it must first be established that debt is not always avoidable. This is not just because of things such as mortgages and car loans but also unexpected situations which require a bit of additional financial support. Accidents or injuries, home repairs, unavoidable purchases, etc.
This article aims to do two things:
- Provide information on what you must know before taking on any debt
- Explain the difference between good debt vs bad debt
Annual Percentage Rate
When talking about debts, you must look not just at the amount you are borrowing but the interest rate you pay for your borrowing.
The most common debt comparison figure is the APR (annual percentage rate). Any type of loan you take out will come with an APR, which is the percentage of interest that you must repay on the loan each month. Different loans have a different average APR across all product options. Mortgages and refinances are often on the low end while credit cards and payday loan are usually on the higher end. Secured vs unsecured. Knowing what the APR is of the loan you take out is one of the first pieces of information you should obtain.
Though APR is used as a simple comparison tool you must not forget to review any fees, charges or other small print costs involved. A super low interest rate might look very attractive but if it comes with enormous fees to obtain it in the first place, and perhaps exit penalties to pay it off ahead of schedule, you must look at the total cost of borrowing.
Debt Term
The debt term refers to how long you will be repaying the debt. Typically, the shorter the term, the higher the repayments. With a loan structured this way, it’s important to understand that though the repayments are higher, the shorter term means the quicker you repay that debt and the less amount of time you will incur interest.
Take a mortgage for example. Mortgages usually have lower interest rates over a longer term, on average 25 years. Though the APR is considerably lower than, say, a personal loan, the lengthy term period can accrue an interest of hundreds of thousands of pounds. A personal loan might charge you a much higher rate but if you pay that money off in a couple of months, that total cost is relatively limited.
Too Good to Be True
Be wary of any deals that looks too good to be true. If you see a rate of interest that’s much lower than the market average, there is usually a catch. Is the interest rate very cheap for a short introductory period? Does that then lead into a much, much higher interest rate for the remaining terms of the loan? Is the overall amount of interest repaid more or less expensive than if you had a consistent, medium rate of interest for the entire period? If the low interest rate followed by the high interest rate would end up costing you more, it might not be a sound financial decision.
The caveat to this is if you know you can repay your debt during the lower rate interest or interest rate free period. Just make sure that there are no fees for repaying the debt sooner, or if there are that this cost would be less than the interest had you seen the load period out in full.
Repayment Structure
Before you take on any borrowing, whether that’s an overdraft, credit card loan, mortgage, et cetera, you must have a clear plan of how and when you’re going to repay that debt. Borrowing without a clear repayment plan is how you can very quickly get yourself into financial difficulties that can have major long-term repercussions to your finances, your credit rating and mental well-being. But which debts should you aim to repay first?
When comparing debt, we already talked about the underlying interest rate being the main factor when choosing which debt to take on. This is also true when looking at repaying those liabilities. The most expensive debt is not necessarily the highest monthly payment. It is the one with the highest interest rate cost.
If, for example, you pay £500 a month of a personal loan with an interest rate of 3%, but £100 a month of a credit card that has an interest rate of 35%, it’s the latter you will ideally focus on paying off first. Sometimes cash flow dictates your priorities but wherever possible pay off your debts with the highest interest rate first.
Personal Loan from Friends or Family
Another debt factor to consider alongside interest cost is a personal loan from family and friends. This might be offered on very cheap and discounted terms to help you or them out. Though beware the impact it can have if perhaps you get into difficulties making repayments or they expect the money to be repaid sooner than it has been. The last thing you want is a difficult situation between family and friends because of a financial matter that can affect your long-term personal relationships.
Debt and Mental Health
The other fundamental concern about debt (good or bad) is the mental health aspect of owing money. According to the mental health foundation one in three people (32%) said worries about ‘being able to afford to pay my bills’ made them anxious in the last two weeks. 20% said ‘debt.’
Taking on debt can adversely impact individuals, couples, family units and your whole social circle if it becomes too much of an issue. There is support out there if you get into financial difficulties and I can’t recommend highly enough that you seek it as early as possible when you think you might be struggling to repay any liabilities you have. Resources to consider are Money & Pension Services, Citizens Advice and National Debtline.
Now that we’ve reviewed the main factors to consider when taking on a debt, let’s get into the difference between good debt vs bad debt.
Secured vs Unsecured Debt
A good place to begin when trying to quantify debt is secured vs unsecured. Secured debt is debt that is taken against some form of collateral, such as a property. Since there is an asset attached to the money you have borrowed, the loan is considered secure as the asset has an inherent value. As a result, the interest rate on this type of loan is typically on the lower end.
Unsecured debt is debt which is not taken against any form of collateral. Payday loans, credit cards and personal loans are unsecured debt. These types of loans will usually have a higher interest rate as lenders do not have a tangible item to repossess should you default on the loan. At face value, good debt is secured, and bad debt is unsecured. However, there is more to this.
Debt on Investments
Good debt can also be considered borrowing you take to help finance an investment or an asset. Earlier, when mentioning long term debt we discussed mortgages. Buying a home will quite possibly be the biggest financial transaction a person makes in their life and the idea that you could end up paying hundreds of thousands of pounds in interest might not naturally seem like a smart idea. However, this debt is an investment as there is a high likelihood that the property will appreciate in value overtime.
Debt on Lifestyle
Oftentimes people feel pressure to keep up a certain lifestyle even if it is above their means. This can quickly lead to credit card debt, high-rate payday loans or living with overdraft fees. This lifestyle debt is the type of debt one could refer to as bad. It is not on investment like a mortgage is. It is not a necessity like a home repair or medical cost. It is debt incurred for other expenditure that you can’t afford to repay. This is the type of debt that will come with high interest rates, hefty penalties for missed payments and potentially lead to a cycle of stress which becomes unmanageable.
Affordability
The simple answer to the question what is the difference between good debt vs bad debt is how expensive the debt is. When it comes down to it good debt is the debt you can afford to repay. Bad debt is the expensive debt where the interest can escalate beyond your capacity to repay it. This is often in the form of unsecure loans for expenditure that maintains lifestyle and appearances.
Good debt is the debt that has the potential to lead to financial growth overtime, or debt that has manageable repayments. Knowing what to look for and understanding the logistics of the debt when making comparisons will help you understand what is best for you.
When considering debt, focus on paying off the most expensive credit and always having a repayment plan before you borrow money. Circumstances can change rapidly and even a sensible plan at outset can become unsustainable if we suffer unfortunate changes to circumstances. The key here is not to bury your head in the sand seek help or support and do it and then the scope of your problem can be massively reduced.
Article by Adam Nettleship
Managing Director, Bigmore Associates
If you are in need of advice on your financial plan, get in touch with the team at Bigmore Financial Planning by filling out the contact form below.
