Debt is a financial tool that many individuals and businesses use – to achieve their goals and manage their finances. Being in debt at some point in life is almost inevitable for most people.
Unless you are born with a silver spoon in your mouth, there will be times when a person needs to borrow money (for education, college tuition, for home or in case of an emergency).
Although most people tag debt with sheer negativity, managing debt effectively involves strategic planning and investment; and sometimes it could be a smart choice to revamp your life completely.
However, not all debts are created equal.
Debt can be categorised into two main types: good debt and bad debt.
Good debt can help you build wealth and achieve financial goals, while bad debt can lead to financial troubles.
If you take a closer look, debt often has a positive flip side. With good loans, you could add a specific value to your life. Certain things like education, home etc. are smart purchases to a happy and financially abundant life.
In this article, we will be dealing with the concept of Good debt and Bad debt and how a seemingly innocent good debt could turn into a blood-sucking vampire and how to avoid it.
What is good debt?
Good debt is defined as a loan that will eventually help you to generate more income to increase your net worth. Good debt is an excellent investment for a promising financial future.
Good debt is often considered an investment in your financial future. It is typically used to acquire assets that have the potential to increase in value over time.
When it comes to good debt, you will have an exact reason for taking it and a realistic plan for paying back the amount very soon without entangling yourself into a financial mess.
Someone who is planning to be in a good debt will have discovered the cheapest option to borrow the money and would have carried out extensive research on the interest rate, methods of borrowing, terms of payment etc.
Let us take a look closely into some of the different types of good debts.
1. Mortgage
Taking out a mortgage to buy a home is often considered good debt because real estate tends to appreciate in value.
This is probably one of the most justifiable causes for getting into debt. Mainly due to two reasons. Firstly you need a place to live, and secondly, you will have an asset which will last for a long time.
Studies have shown that in several parts of Malaysia, housing prices continue to rise at a steady scale. The good thing about mortgages is that once you have finished paying, you will have an asset that is usually worth far more than what you have borrowed.
Mortgages usually have lower interest rates when compared to other forms of debt. Furthermore, it is a suggested approach to save money rather than spending it on rent every month.
2. Educational loan
Educational loans provide support for those who aspire to gain a higher college degree. Borrowing money to invest in education can be seen as an investment in your future earning potential.
With better education, a person’s future is more likely to improve and be secured as the chances are high that he might end up in a high paying job.
Before planning to take an educational loan to enrol in the course of your choice, it is better to carefully examine the pros and cons of the degree of your particular interest.
If there is a lack of demand or a job opportunity coming up with the course that you are studying, chances are most likely that a good debt could turn out into a bad one.
3. Loans for Business
Investing in a business can be a great idea if you have a smart business plan. Small business loans are hard to get as the extent of risk is considered high from the perspective of the lender.
Research has shown that almost one-third of small businesses fail to survive their initial two years. If you are ambitious to build a business with a smart plan in place, borrowing money to start with will be an excellent investment.
4. Real Estate
Studies have shown that the Malaysian real estate industry is slowly picking up a good pace.
It is no surprise that many people are rushing to invest in the real estate market. Make sure that you have thoroughly researched the pros and cons before investing. Without a thorough knowledge, any good investment can turn into a bad debt quickly.
What is bad debt?
Bad debt, on the other hand, is debt that does not contribute to your financial well-being and can often lead to financial problems.
For example, a loan that continually drains your wealth, is not affordable and offers no likelihood of paying for themselves in the future is a bad debt. These are the ones which decrease in value after you have bought it.
You might be surprised to know that most of the purchases you make for life’s necessities such as household equipment, your brand new LED TV, game console etc. are part of bad debts.
One interesting thing about bad debt is that in the long run, you will lose more money which can eventually lead to bankruptcy proceedings being initiated by your creditor. These come up after a court judgement is obtained against you/your firm declaring you financially incapable of paying the debts.
Now this is not just a bad name earned for yourself but also a tough legal situation to get out of.
So, unlike the good debts, bad debts have no realistic plans for repayment, and most of the payments are made impulsively. Therefore, eliminating bad debt is a crucial step towards financial stability.
Here, a person who is borrowing money will have no certainty whether he will be able to repay the money or not.
Examples of bad debts:
1. Credit card debts
When used correctly, credit cards could be a life saviour, like in the case of an emergency. Credit card debt often becomes bad debt when you use it to make large purchases and pay a minimal amount every month. It can be even worse if you delay the payment after the due date resulting in a high-interest rate and not to mention a bad score on your credit report.
2. Automobile loans
For most people having their car will help to save a lot of waiting time in their life.
But you need to be careful before planning to purchase a new car. Ask yourself the question, are you stable in your job? Can you afford to pay back the amount? Is it possible for you to balance the monthly expenses?
Brand new cars lose their value after a certain period, and for certain brands of vehicles, the resale value is meagre.
The interest rates of automobile loans are relatively low, which is one of the main factors that attract people. The most financially prudent move is to choose a car which fits your budget and avoid going for an expensive one.
3. Borrowing money to pay the bills
If you are caught up in a vicious cycle of constantly borrowing money to get to the end of the month, it is guaranteed that you are soon going to be entangled with really bad debt.
Financial counselling will help you to make fine adjustments to ensure that you could effectively manage your finances.
How to use a debt wisely?
Bad debt can lead to financial stress, damaged credit scores, and a cycle of debt that is difficult to escape.
However, when used wisely, debt can be a powerful tool for achieving your financial goals. Here are some strategies for using debt effectively:
1. Strategic planning
- Set clear financial Goals: Determine what you want to achieve with your debt, whether it’s buying a home, starting a business, or advancing your education.
- Budget carefully: Create a budget that outlines your income, expenses, and debt repayment plan.
2. Investment
- Invest in income-producing assets: Use good debt to acquire assets that generate income, such as rental properties or dividend-paying stocks.
- Business loans: Entrepreneurs often take on debt to fund their businesses, with the expectation that it will generate income.
- Diversify your portfolio: Spread your investments across different asset classes to reduce risk.
Tips to get out of a debt as soon as possible.
1. Spend less than what you actually plan to spend
Most people find themselves in debt, mainly because they purchase things beyond their normal ability. If you want to buy something, don’t purchase it unless you have money to buy it.
2. Pay more than the minimum
While you are paying back the monthly credit amount, always make sure that you pay more than the minimum payment. Always make regular and timely payments on your good debt to maintain a positive credit history.
For people who only pay the minimum amount, it will take forever to close the debt.
If you want to pay back the balance quickly, you should pay as much extra as you can afford.
3. Close the most expensive debt first
Remember that eliminating bad debt is a crucial step toward achieving financial stability.
If you are someone with a vast list of debt, it would be wise to focus on the debt which is charging you the maximum interest.
It doesn’t mean you should avoid paying back other debts, but instead focus on the most important one and clear it off as soon as possible.
Consider consolidating multiple high-interest debts into a single, lower-interest loan. Once you have finished paying it, focus on the second most important one, followed by others.
4. Keep a thorough check on unnecessary spending
Keep a track on all your spending in a month and identify the areas where you tend to spend more. This not only helps to give you an understanding of your spending habits but also to identify the areas where you can save.
5. Get a second job
This is an ideal way to pay back your debt at a quicker pace. The extra income that you earn through your second job will help you to be free from debt in a short number of years.
FAQ
How do I know if a debt is good or bad?
Good or bad debt depends on its nature and purpose. Good debt is for investments that gain value over time, while bad debt is for consumption or depreciating assets.
What are effective ways to boost my credit score?
To improve your credit score, manage good debt well and work on eliminating bad debt. Always pay on time and avoid delays.
Is there risk in using good debt for investments?
Investing with good debt carries risks like market volatility and possible asset value decline. Research thoroughly and consider spreading out investments.
How can I work with creditors to lower my debt?
To lower debt, you can talk with creditors about reducing the payoff amount or lowering interest rates. Debt negotiation professionals can help in this process.
Which should I pay off first: the smallest debts (debt snowball) or the highest interest debts (debt avalanche)?
Choosing between paying off small debts first (debt snowball) or high-interest debts (debt avalanche) depends on your financial aims and personal preference. The debt snowball method offers quick wins, whereas the debt avalanche method is more cost-effective in the long run.
Bottom line
At some point in life, everyone has to deal with debt. What really makes a difference is your planning to prevent the good debts from becoming bad debts.
By carefully analyzing your financial picture, you can decide on an effective way to pay off your debts. Ideally, it is better to focus on paying back the bad debts first since they are costlier and provide no value.
Finally, make sure you never end up in too much debt, even if it’s a good one. If you are overburdened with debt, it doesn’t matter whether it is good or bad, it will still hurt your financial health.
By maximising the benefits of good debt and eliminating bad debt, you can work toward achieving your financial goals and securing a stable financial future.
Get in touch with a debt counselling agency to understand how you can pay back your loans without getting into serious financial and legal troubles.
