Good debt vs bad debt

Inflation, constant interest rate hikes and just the general difficulty of getting through the month nowadays have forced many South Africans into making debt. And while we may still have our parents’ voices drilling it into our heads that any debt is bad, this is not necessarily true. There is such a thing as ‘good’ debt, and it can actually improve your credit score, help you get better interest rates on loans and ultimately add to your life in a meaningful way.

Good debt

There are very few people who can put down cash for the big buys of life like a car or a home. Good debt is the kind of debt that increases your net worth or improves your and/or your family’s life in significant ways. It could include:

  • Student loan
    Student loans can be seen as an investment in your future if the qualification is going to help you secure lucrative employment. Be careful of investing tens, or even hundreds, of thousands into a qualification that may not get you a well-paying job, because you will still have to pay the loan off.
  • Mortgage loan
    Why pay off someone else’s bond when you can pay off your own? A mortgage is one of the best kinds of debt, because you are left with an asset that generally appreciates in value over time. However, it’s important to determine what level of expenditure you can afford – rather get the smaller house that you can comfortably afford than the bigger one that you can just barely make the payments for, or this ‘good’ debt can quickly dwindle over into the territory of a ‘bad’ debt.
  • Borrowing to consolidate debt
    A debt consolidation loan is good debt, as it combines many of your crippling debts into one, more manageable loan and repayment plan. It may also have a lower interest rate than the individual loans. This helps you clear your name and regain your financial future.

Gray areas

Oftentimes, a loan can be considered good or bad depending on your particular circumstances. For example, a vehicle loan can be seen as good if having the vehicle allows you to get to your job and avoid costly transport fees. But splashing out on high-end vehicles that are more for show than for getting you from A to B makes a vehicle loan a bad debt – especially if you are unable to afford the monthly repayments and end up defaulting.

Credit cards can be seen as good debt if you keep their use limited only to emergencies, and make sure you always pay them in full every month. Using a credit card to purchase frivolously like expensive clothing, holidays, eating out, etc is unwise and, because of the high interest rate, puts this kind of loan firmly in the bad debt category.

Bad debt

Bad debts are those that drag you down financially, and usually have high or variable interest rates. They are used for discretionary purchases or for things that lose value. But any debt that you are unable to afford in the long run becomes a bad debt. The obvious culprits include:

  • Clothing accounts
    Everyone needs clothes, but store accounts encourage unnecessary spending and often come with high interest rates. Don’t fall into the trap of spending too much on clothing you will get only temporary pleasure from, but will have to pay off long after they’ve lost their appeal.
  • Luxury items on credit
    It’s nice to have nice things, no one’s denying that, but you don’t really need the brand-name coffee machine, high-end holiday or fancy car. Lending money to spend on frivolous, unnecessary items will only hurt your financial future and bring you no long-term gain.

The takeaway: Good debt grows your financial wealth and future in the long run. Bad debt degrades your financial future and is often spent on unnecessary nice-to-haves. However, any debt that you cannot afford to repay becomes bad debt.