Good Debt and Bad Debt

Good Debt and Bad Debt

19 Sept 2019

A few types of debt may be good for some people but bad for others, but borrowing money and taking on debt is the only way many people can afford to purchase big-ticket items like homes and cars. As a prudent measure, you should always separate the good debt from the bad debt to keep your debt firmly under control and within manageable limits. If left unchecked, it could snowball into a debt trap if the borrowings become excessive.

Let us understand these concepts of good debt and bad debt in greater detail as under:-

Good Debt: A good debt is defined as a debt that helps you generate additional income from your investments or through the growth or appreciation in its value. There will be relatively lower rates of interest if you consider good debt. It works out to be quite economical when one factors in the tax benefits of a home loan. Some examples of good debt are underlined below:-

  • Home loan - Taking out a mortgage to buy a home is usually considered good debt as well. Like student loans, home mortgages generally have lower interest rates than other types of debt, plus that interest is tax-deductible. Even though mortgages are long-term loans (30 years in many cases), these relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies.
  • Education loan - Student loans typically have very low-interest rates compared to other types of debt. Secondly, a college education increases your value as an employee and raises your potential future income.
  • Auto loan for a business - An auto loan is another example of a good debt, particularly if the vehicle is essential to doing business. Unlike homes, cars and trucks lose value over time, so it's in the buyer's best interest to pay as much as possible upfront so as not to spend too much on high-interest monthly payments.
  • Small business loan - If you start your own company and work for yourself, you may require a loan for financing your business operations. Small business loans are tougher to get because they are riskier to the lender. Almost one-third of small businesses fail to survive their first two years, according to the Small Business Administration. But if you have enough ambition, are both savvy and lucky, borrowing money to start your own business could be the best investment that you will ever make.

Too much of a good thing is bad. Thus, you should not unnecessarily extend your budget to buy a house and always limit your home borrowings to the minimum by making down payments for at least 20% of the property value. If you are planning to take education loans, do not borrow more than a year of your expected first-year salary.

Bad Debt: A bad debt is something that you take to own depreciating assets. You have resorted to bad debt if the asset you buy from the debt would not go up in value or generate any meaningful income.

  • New cars, in particular, cost a lot of money. While you may need a vehicle to get yourself to work and to run the errands that make up everyday life, paying interest on a car purchase may simply turn out to be a waste of money. For instance, taking a loan to buy a car because the value of the car depreciates by 15% to 20% is one classic example.
  • Another example is of a credit card debt that becomes bad once you start delaying payments. Credit cards are one of the worst forms of bad debt. The interest rates charged are often significantly higher than the rates on consumer loans, and the payment schedules are arranged to maximize the costs for the consumer.

To sum up, not all debt can be classified as good or bad so easily. Often, it depends on your own financial situation or other factors. You should always keep an eye on your overall debt and ensure that all EMI payments put together are limited to 35% of your take-home salary or lesser. Keep your overall debt within limits without affecting your savings towards important financial goals.

Founded in 2005 by new–age entrepreneur Abhishek Bansal, the Abans Group has evolved into a globally diversified conglomerate, providing expertise in Broking Services, Non-Banking Financial Dealings, Financial Services, Agri-Commodity Services, Warehousing, Realty & Infrastructure, Gold Dore Refinery & Manufacturing, Trading in Metal Products, Pharmaceuticals, Software Development & Wealth Management. The Group is a comprehensive financial and non-financial services and solutions provider, aiming to provide end-to-end solutions to its clients.