Alexandra Cain Finance Writer
The ability to borrow money to fund certain purchases is one of the best aspects of the modern financial system for consumers.
But not all debt is created equal. There’s a real difference between good and bad debt and it’s important to understand the distinction between the two to put yourself in the best financial position possible.
What is good debt?
Good debt is debt used to fund the purchase of assets whose value is expected to rise over time.
A good example is debt used to fund the purchase of your home. The mortgage you take out will be paid off over time, and at the end of the term you will own your own home.
Another example is a loan taken out to fund the purchase of an investment property. It’s likely the rent paid by tenants will largely pay down the loan used to purchase the property. Again, at the end of the term you will own an asset whose value has hopefully appreciated, and will continue to appreciate.
What is bad debt?
In contrast, a bad debt is a loan for items that will lose value or be consumed.
Common examples of bad debts include loans taken out to fund a holiday and using credit cards to pay for clothes and entertainment.
Smart ways to use debt
With any kind of debt, it’s important to make sure that you only borrow what you can afford to repay.
Here are some tips for smart ways to use debt and minimise the interest you need to repay:
- Save a larger deposit on any personal loan – this will minimise the amount you need to borrow and the interest you will repay
- Open a high interest savings account and make regular deposits rather than taking out a personal loan for major expenses like holidays
- Consider a credit card that offers additional benefits such as complimentary travel insurance and loyalty points, and be sure to pay the balance during the interest free period
Although sometimes you may need to take out a loan or use a credit card, if you are aware of the risks and manage them carefully, you can minimise taking on bad debts. Understanding the difference between good and bad debt will also help you to focus on borrowing money to fund assets that will appreciate in value over time.
Please note that this article is not financial product advice and does not take into account any person’s individual objectives, financial circumstances or needs.