Debt is bad, right? Actually, it’s not that simple. We take a look at good versus bad debt and explain how debt can be a useful financial planning tool to leverage opportunities for wealth creation when used correctly.
A common misconception: all debt is bad
Generally, we advise clients that the first step in their financial planning journey is to pay off their debts. But what we really mean is to pay off their bad debts. So how do we define bad debts? What are good debts? And what place does debt have as part of a comprehensive financial plan? Let’s take a look.
What is debt?
You incur a debt when you borrow money or resources from another party. When your creditor is a bank, credit card company or loan company, you agree to repay the debt according to certain criteria. Generally this will include an agreed payment schedule or minimum monthly payments, and a specified interest rate, which could be fixed or variable.
You may take on debt for many different reasons: to buy the latest iPhone or a new car, own your own home, finance a university education, start or expand a business or fund a luxury holiday.
Debts can be secured or unsecured. Secured debt is borrowing that is backed by collateral, such as real estate or a vehicle, providing the lender with an asset they can claim if you default on the loan.
Unsecured debt, on the other hand, is not backed by collateral. Obtaining this kind of loan relies solely on your creditworthiness. The increased risk to the lender means that interest rates are significantly higher for unsecured debts.
Good debt versus bad debt
Debt can be a terrible burden that costs you a lot in interest with no benefits at all over the long term. But it can also be a useful financial planning tool to leverage opportunities for wealth creation.
Good debt includes loans that are considered to be an investment in your future financial well-being. These debts typically involve low interest rates and have the potential to increase your net worth over time.
A mortgage that enables you to purchase a home would usually be good debt because your real estate investment is likely to appreciate in value over the long term. The key is to borrow an amount that aligns with your ability to repay the loan at an interest rate that you can cope with. It’s wise to give yourself a lot of wiggle room if rates are likely to change. The current mortgage crisis in the UK illustrates how quickly debt can spiral when interest rates change.
Other examples of good debt are student loans to invest in a degree that will increase your earning potential and career opportunities, or a business loan to finance a business venture that will generate income.
Good debt helps build wealth and financial security through home equity, increased income or the growth of a business. All these things are likely to yield positive results if managed correctly.
Bad debt, on the other hand, includes borrowing that does not contribute to your long-term financial stability. Indeed, high interest rates and unfavourable terms mean that these debts can easily damage your financial situation if not strictly managed.
Examples of bad debt include credit card balances that accumulate high interest without a clear repayment plan and personal loans for non-essential items which often come with exorbitant interest rates.
Bad debt can be a significant obstacle to achieving your financial goals. It can lead to financial stress, reduced savings, and, in extreme cases, financial ruin. High-interest rates on bad debt can cause the amount owed to get out of hand, making it difficult to escape the cycle of debt.
Using debt wisely: some dos and don’ts
The key to making debt work for, not against, you is to use it wisely and responsibly.
Here are some dos and don’ts to help you navigate the world of debt successfully:
Do clearly define the purpose of any debt and consider how it aligns with your financial goals. If there is no long-term benefit, don’t go there.
Don’t take out debt for non-essentials. You really can do without the new car/trainers/tech. If you can’t afford a luxury item without resorting to credit, go old school and save up instead.
Do shop around for the best terms. If you are taking on a debt such as a mortgage, compare interest rates, fees, and repayment terms from multiple lenders to secure the most favourable conditions and minimise the cost of borrowing.
Don’t overextend yourself. Resist the temptation to take on more debt than you can comfortably manage within your budget, as this can lead to financial strain and missed payments.
Do have a repayment plan. A well-structured repayment plan that fits your budget will enable you to meet all your payments on time and maintain a positive credit rating.
Don’t pay off the minimum amount on credit cards. You’ll end up paying back far more than you borrowed in the first place.
Do build an emergency fund. Having savings to cover unexpected expenses will eliminate the need to rely on high-interest credit for emergencies.
Don’t ignore the small print. Always ensure you read and understand the terms and conditions of any debt agreement, including interest rates, fees, and penalties, to avoid unpleasant surprises.
And finally….
Do seek professional guidance.
Your financial adviser can help you to understand the implications of various debt options and ensure your financial strategies are aligned with your long-term objectives.
Debt and financial planning
Understanding the distinction between good and bad debt is essential for making informed financial decisions and ensuring that debt serves as a tool for financial growth rather than a burden on your financial well-being. By carefully considering the purpose and terms of any debt you take on, you can make strategic choices that align with your financial goals.
For further help with making well-informed financial planning decisions, why not book a call with one of our highly experienced advisers? We could help you achieve your goals more quickly. Contact us to set up an initial chat.
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