Knowing the difference between good debt and bad debt
Few of us will ever avoid being in any sort of debt throughout our lives, but it’s important to remember that there are such things as ‘good debt’ and ‘bad debt’.
One can seriously damage your credit rating, while the other can be used to improve your chances of getting anything from a credit card to a mortgage – but what do you need to know about each?
Good debt is generally considered to be borrowings that can help to create value. These can include products such as student loans – your aim is to gain qualifications which will allow you to command a higher salary – or a business loan (spending money to make money).
With good debt, there is always a plan in place of how the money will be repaid and what difference the service will make to your life.
An easy way to think about this is by considering what happens when you take out a mortgage on a family home – a popular form of good debt. Unless you win the lottery, you’re unlikely to be able to buy the property outright, but by purchasing a chunk and lending money to cover the rest, you can generate wealth if the property is sold for more than you bought it for.
On the other hand, bad debt refers to a situation where there is negligible gain from borrowing money to buy something. For example, if you spend hundreds or thousands of pounds on a credit card on disposable goods such as designer clothes, you need to have a plan in place of how you will pay this back.
Never mind the fact that the clothes will instantly dip dramatically in value once they’ve left the shop; without a plan in place of how you will pay back the money, you could end up in a spiral of debt that could lead you to insolvency or even bankruptcy.
Do credit cards create good or bad debt?
The above does not mean that credit cards entirely generate bad debt. Indeed, a credit card can create good debt if you manage your money properly.
Credit cards afford far more protection than debit cards or paying in cash, meaning they can be a safer bet for large purchases such as holidays. If a travel firm goes bust, you’re far more likely to get your money back with a credit card than a debit card.
If you simply pay off the credit card bill with money from your current account or savings, you’ll be able to enjoy the freedom of spending in the black while taking advantage of the spending protection afforded by a credit card – the best of both worlds.