Debt: this is a word which often evokes negative feelings and is associated with poor financial decisions. However, having debt is not necessarily a bad thing. While we all wish we had the money to make big purchases or invest without going into debt, the reality is that it is not always possible. In some cases, it is therefore financially smart to take a loan.
The truth is that almost everyone will have to take a loan at one point or the other. But how do you tell that a loan is the best move to make? How do you tell if the cost of interest is worth the benefits? Well, as a rule of thumb, a good debt benefits your financial future while a bad debt harms it. In addition, all debt is bad debt if you can’t afford to pay it.
Here are some examples of both good and bad debt:
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Verdict: Good Debt
No everyone has parents who are able to pay the ever-increasing tuition fees charged by universities and colleges. For many people, student loans offer an opportunity to pursue higher education, which potentially opens the door to career options and a higher earning potential. Studies have shown that people with a Bachelor’s degree earn 66 per cent more in their lifetime than those who don’t have a degree.
While most parents prioritise saving for their children’s college education, financial experts recommend that they pay more attention to saving for retirement. This is because their children can take loans to finance their college education or even apply for scholarships. Meanwhile, there are no loans for retirement.
Therefore, taking a student loan is generally a good debt. Student loans, especially those funded by the government, tend to have the best repayment terms of any loans out there.
Owning a home is one of the best financial decisions you can make. Research shows that millennials spend up to 45 per cent of their income on rent. When money goes into contributing to mortgage payment rather than rent, you will be assured of eventually owning the home, which is a great asset for retirement.
Financial experts consider this a neutral debt because while it doesn’t help you make money, it does help invest in future value. Homes are very expensive and the only way for most people to own them is through taking out home mortgage loans.
A home loan turns into a bad debt if you overstretch yourself. In general, your mortgage payments shouldn’t take up more than a third of your income – which is also the recommended amount to spend on rent.
Some people might also direct most of their cash flow into aggressively paying down their mortgage. This can be a mistake if the cash is for other needs or for investing in long term goals. If your income takes a hit and you have a home loan you’re repaying, you will have high-fixed costs and little flexibility to scale back.
Verdict: Good Debt
Most entrepreneurs use small business loans to start or grow their businesses. Because a business loan can help you increase your future cash flow, it is considered as a good debt.
In addition, when applying for a business loan, you are often required to create a comprehensive business plan –which forces you to examine your goals more closely.
You can use a small business loan to cover the expenses of expanding your business, offset inventory costs, to support your regular operational costs so your business can stay afloat during tough times, to buy equipment that will boost your business, or even to improve the terms on a larger loan.
Credit Card Debt
Credit cards often get a bad rap. But when used responsibly, credit cards can be a good debt. They also come with awesome rewards such as cash back for purchases, accruing frequent flyer miles, can help in settling disputes with vendors, and give you the opportunity to build credit. They also reduce the need to have cash on you, which can reduce the risk of being robbed.
But if you use credit cards to buy things you can’t afford, they can easily help you rack up thousands of shillings in bad debt. The key to using credit cards wisely is to pay your statement balances in full , and on time every month. This ensures that you get to use your credit card at no monthly cost, which means you’re receiving an interest-free loan each month.
If you can’t pay your statement in full, always make sure you pay more than the minimum balance. Make frequent payments and restrict the use of your credit card to only basic bills rather than impulse purchases.
Verdict: Bad Debt
Are you tired of taking a matatu to and fro work? You are probably considering taking a car loan. But most financial experts are of the opinion that taking a loan to buy a car is “bad debt.”
Cars depreciate in value the moment you drive them out of the dealership. Paying interest for years on an asset that is continually depreciating is one of the things that can hamper your financial growth. If you feel a car is necessary and you don’t have the money to buy one, it’s best to go for a second-hand car. Used cars are cheaper and don’t decline in value as fast as brand new ones.
Verdict: Bad Debt
Banks often advertise payday loans – which are usually small loans which are deducted from your next paycheck. It’s therefore something like a salary advance.
Although a salary advance loan can be a real life saver when you have an emergency, you shouldn’t get in the habit of taking them. A better plan is to create an emergency fund to cater for unforeseen expenses. Payday loans charge exorbitant interest rates which can add up to a significant amount if you take such loans regularly.