Debt is often viewed as something to be wary of, but while it can lead many to make poor financial choices, borrowing money isn’t always a bad thing. Used correctly, it can help individuals get on the property ladder and enable businesses to grow.

Understanding the difference between good and bad debt is therefore crucial if people are to make sound decisions when it comes to leaning on third parties for finance. In this post, I’m going to delve into what constitutes the light and dark sides of debt.

What is good debt?

You’ll doubtless have heard the phrase ‘it costs money to make money’; that’s a direct reference to good debt, which, when used properly, can increase net worth and help generate income.

Types of good debt

  • Mortgage. Getting on the housing ladder is something many people aspire to. It’ll likely be the largest loan you ever take on, but because it is secured against a property which, come the end of the loan period, you’ll own and – all being well – be able to make a profit on, your mortgage is a prime example of good debt.
  • Student loans. University life doesn’t come cheap. By taking out a student loan, you’ll have the financial backing required to become a graduate. Such loans also benefit from low interest rates and you only have to repay once you reach a certain income threshold. The benefit of a student loan is that it improves your education which in turn should enable you to earn more in the future.
  • Business loan. If you’re starting a new venture, you’ll likely need some capital to get it off the ground. Business loans have long been a way to help entrepreneurs realise their business plans, and are a perfect example of how debt can generate income.

What is bad debt?

Even good debts can have their downsides; you are, after all, still in the position of owing someone else money. Bad debt, on the other hand, only offers downsides and you should avoid it. By and large, if you borrow money to buy something you can’t afford, you’ll quickly sink into bad debt.

Types of bad debt

  • Unnecessary purchases. Let’s use the car as an example. Sure, you want the GTI version, but can you afford it? If not, you should lower your expectations. Car finance typically includes schemes such as hire purchase, which, while often a sensible way to borrow money, will force you into arrears if you’re unable to afford whatever it is you’re buying.
  • Credit cards. In November 2015, UK consumers collectively owed a whopping £178.2bn on credit cards and loans. Using plastic to make purchases is fine, providing you pay the balance before the interest hits. However, fall out of that habit, or overspend on a credit card, and you’ll quickly fall into bad debt.
  • Borrowing to pay debt. If you’re already in debt, or have fallen behind on a utility bill, borrowing again to make payments is completely counter-intuitive – you’ll only be plunging yourself further into debt by shifting what you owe from one creditor to another.

How to avoid bad debt

Before borrowing money, there are five questions you should ask yourself. If you answer ‘no’ to one or more, the debt is likely to be bad:

  1. Will the debt help improve my finances in the future?
  2. Can I afford the combination of the loan amount and interest?
  3. Will I be able to afford the monthly payments?
  4. Am I fully aware of the risks should I fall into arrears?
  5. Do I 100% need the item for which I’m borrowing money to buy?