Debt is a scary word. Owing your friends or the bank money can make you anxious. However, debt isn’t as bad as we might think. Unbelievable right? Most of us don’t know that debt is a strategic tool to improve one’s long-term finances when used responsibly. There is good debt and bad debt, and we will have a look at their differences. We need to understand what makes debt a good or a bad thing before we proceed.
What makes debt ‘good’ or ‘bad’?
Let’s look at what defines debt. First, the concept of good versus bad debt comes into play when applying for a personal, home or business loan. Good or bad debt is dependent on two factors. The first is the loan terms, and the second is the APR (annual percentage rate) charged on the principal (the loan amount)—what we know as the interest rate.
The interest rate is the percentage of the principal (the loan amount) that the lender charges the borrower for using the money. Interest is calculated from the unpaid portion of the loan outstanding. Sometimes the APR may include brokerage fees or closing costs for large capital purchases.
What is the difference between good debt and bad debt?
In simple terms, a good debt is a good investment and helps you grow. As much as being debt-free is financially responsible, good debt can improve your life, create wealth and improve your future earning potential. For instance, Taking a student loan is an example of a good debt because education can improve your chances of employment and secures a bright future. Other good debts include house loans to build apartments for rent to earn a passive income. On the other hand, debt is classified as ‘bad’ when you don’t pay on time; and your account goes into arrears. Also, it includes buying luxury goods you can’t afford and taking loans from unregulated institutions to finance an immediate need. These institutions will coax you into taking their loans and hound your life for payment. A typical example of bad debt is a payday loan. In the case of payday loans, you receive a cash advance; plus a fee with a high-interest rate. If you fail to pay the amount plus the processing fee by the expiration date (usually your next payday) — the loan “rolls over” and incurs another processing fee.
How do you avoid bad debt?
Ask yourself these questions If you’re thinking of taking out a loan or going into debt. Here are some of the questions you should have answered.
- Is this loan the only option available to me?
- What are the interest rates? (Sometimes a low-interest rate may come with high charges, so do your research.)
- What are the repayment terms? Can I pay on time?
When repaying your debts, you need to keep track of your income and whether you can repay on time. With Fluid Finance, track your earnings, current account and investments all in one place.
Conclusion
Debt is a strategic way to grow your net worth. However, whether ‘good’ or ‘bad’, too much debt can add up. Even good debt can become bad debt if not handled correctly. For instance, paying off your student loan becomes difficult if you’re unable to secure full-time employment. Think carefully before taking out loans or getting a mortgage: if you’re not able to pay money back, it may negatively affect your credit score and financial standing. Managing your debt and repayments is a crucial skill in developing your finances and making your money work for you.
