GOOD DEBT VS BAD DEBT

The question at the top of your mind right now is: “Is there such a thing as good debt?”

I’m right, aren’t I? 🙂

While you should try to avoid debt, there are forms of debt which are necessary and therefore considered to be good debt. Good debt is an ‘investment’ that will grow in value, or generate long-term income.

At some stage in your life you’ll probably acquire some debt, which is okay as long as you manage it and not over indebt yourself. This means your expenses should not exceed your income. You should have a “healthy” disposable income every month.

Here’s what you need to know about the difference between good and bad debt.

GOOD DEBT

Good debt is typically defined as any debt that enhances your net worth or is used as a means to create wealth.

Examples of good debt

Buying a home is considered good debt because your home’s value appreciates over time. You should lower your debt-to-income ratio so that you can increase your chances of qualifying for a home loan.

Taking out a student loan.

Getting a tertiary education is one way of investing in yourself and your future earning potential.

Taking out a loan to start a business is another example of good debt as long as it’s done responsibly, and you take out the amount you need for the bare necessities rather than more than what is required.

If a vehicle helps you to secure better employment prospects then taking out a loan to buy a car is in fact a good thing. I would recommend that you exercise caution when buying a car. Cars that are under residual finance options/balloon payment options (see Pros and Cons of balloon payments) are considered bad debt, so make sure you understand the terms and conditions of your Sale Agreement.

“We need to remember that good debt still has a role to play in every income earner’s life because it has the potential to generate wealth and financial wellness,” says Chief Executive Officer at Glacier, Khanyi Nzukuma.

Good debt should take you forward in life, not backwards. It should be affordable, from a reputable provider and part of a proper financial plan constructed with the help of a qualified practitioner.

BAD DEBT

Bad debt on the other hand is any form of debt that doesn’t enhance your financial wellbeing in any way. It’s usually debt that carries high interest rates that can cripple your finances faster than you can blink.

While taking out a loan for business purposes makes sense, taking out a loan to pay for day-to-day needs such as food, rent and clothing is not ideal and should be avoided at all costs.

“The bad kind of debt, to be avoided completely, is anything unaffordable or that carries punitive interest rates,” Nzukuma advises.

“It’s best to resist the temptation to use debt to indulge a want like expensive cellphones, top-of-the-range cars and home electronics, and use it for a genuine need instead.”

Cars that are under residual finance options/balloon payment options (see ) are considered bad debt.

Avoid balloon payments

A balloon payment of 20% on a vehicle of R240 000 will result in monthly repayments of R4739.58 (over 60 months, at 11.5% interest). At the end of the finance term the repayments total R284 374.84, however the buyer will still owe a 20% balloon payment – or R48 000 – thus bringing the total price of the vehicle to R332 374.84.

If the owner trades in their vehicle, the outstanding balloon amount will be subtracted from the trade-in price. If the owner chooses to keep the vehicle they can pay the amount as a lump sum or finance the outstanding amount, thus incurring further costs.

For a finance deal with no balloon payment the same vehicle would incur monthly repayment of costs of R5 335.23 (over 60 months at 11.5% interest), resulting in a total repayment of R320 113.55 – or R12 261.29 less than the deal with a balloon payment.

Unsecured lending in the form of payday loans is also considered to be a form of bad debt and should be avoided where possible.

 

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Disclaimer: The article is provided for general information purposes only. Whilst care has been taken to ensure accuracy, the content provided is not intended to stand alone as financial advice. An expert should be consulted for advice based on the facts and circumstances of each transaction/case.

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