Good Debt vs. Bad Debt
Having to borrow money has unfortunately become a part of life for some of us. As we often cannot pay cash for our homes, university loans or the car that we use to get to our workplace, we are likely to get a credit. But being in debt is not always bad, since there are things, which are worth going into debt for, whereas others might leave you in a big financial mess.
To differentiate between good debt and bad debt the key is to think about debt as a sensible investment that can help you build long-term financial stability or achieve future goals. For example, a student loan might help you to secure a better-paid job after graduation, or by getting a mortgage you take advantage of rising property prices. If your debt is not an investment in your future that will generate a net-positive return on investment, or you cannot afford the long-term monthly payments, it’s a bad one.
Good debt is used wisely and the sort of credit that you buy essential items to save you time like a washing machine or helps you to invest in yourself such as further education. Especially a mortgage can be filed under good debt as house prices in Australian cities are increasing every year. This means, your home might even gain value every year and living in a house for a few decades that you might even be able to sell off at a profit is a great way to make money in residential real estate.
business loans are harder to get because they are a big risk to the creditor, nevertheless, they might be the best investment you’ll ever make if you want to start working for yourself. After all, it takes money to make money. If you have ambition, skills and the right portion of luck, investing in your first business might be the smart move towards a big monthly pay check, but keep in mind that sometimes even the best ideas don’t always work out as intended before you take the risk of getting into large debt.
Bad debt, however, concerns any purchase, which decreases in value soon after you buy it, or is used for things you cannot really afford. If your purchase won’t go up in value or generate higher income, you shouldn’t go into debt for it. For instance, if you can’t pay cash for either designer clothes, the newest mobile phone, a large flat screen TV or that fancy holiday in Bali but use a credit, all these examples are considered to be bad debt.
To have and live these temporary dreams, credit cards are often used for payment, as the consumers often don’t pay attention to the interest rates. Some credit card companies enjoy rates higher than 15% and are the reason why credit cards are often considered as the worst form of debt since the payment schedules are mostly arranged to maximize costs for the consumer. Hence depending on how long you have to pay off that TV or holiday, the rate might ruin your financial health.
If you can’t afford the repayments, any credit can become a nightmare and you might even end up receiving calls from a collection agency. To prevent this from happening, you will have to find out first if what you are aiming for is actually affordable for you. So how do you know you will be in too much debt soon after the purchase?
To give you a general clue about your financial situation, the most common metric is your debt-to-income ratio. To find out about your ratio, simply add up all your monthly repayments and divide them by your monthly income. For example, if you have monthly repayments of $1,225 and your income is $3,500 per month, it means your debt-to-income ratio is 35%. This ratio is pretty good and means, you won’t be losing sleep over it. Any ratio higher than 43% suggests that debtors might have problems with their repayments and it will be difficult for them to find a potential lender.
Suffice to say, when you’re about to go into debt it depends on how you use it to make it a good or bad one. Always be careful about borrowing money and using credit for something that goes down in value.