Modern life requires many of us to borrow money at some point or another. However, not all debt is bad. In general, there are two kinds of debt: the good debt and the bad debt. But knowing the differences between these two can make a big impact on your decision and overall financial life.
In order to avoid lapse of financial judgment, it’s important to discern whether borrowing money is good or bad and whether you can afford to repay it. At the end of the day, debt can help you manage your finances more effectively like buying the things you need and handle emergencies when used the right way.
But the basic question is when does taking out a loan becomes a legitimate decision? What is the rule of thumb to spot the differences between good debts and bad debts?
Usually, a good debt can be valid once it’s used as an investment that will grow in value or generate long-term income in the future. In other words, the goal is to borrow money in order to make money. Bad debt, on the other hand, means borrowing money for consumption rather than investment.
Borrowing and spending are the two important elements in personal finance. In fact, the reason why a lot of people are in debt is that they keep on spending and they don’t understand the deference between good debt and bad debt. Therefore, it’s crucial to ask yourself whether the type of loan is justifiable and essential.
Borrowing for productive purposes
In a nutshell, good debt simply means borrowing money for reasonable purposes. An example of good debt is a mortgage. You build equity in your home or condominium unit, and the money you pay towards the properties can be seen as investment. It becomes a good debt when you are earning money from the rental properties.
Another example is borrowing money for business purposes that has a high potential to yield income. Also keep in mind that when you started a business makes sure the income from this project should be greater than the interest you will pay.
Bad debt simply means borrowing for unproductive purposes. It can include buying stuff like Smart TV or the latest gadgets at the mall using credit card. Needless to say, they depreciate value over time.
Consider your ability to pay off your debt
Before you borrow money, make it sure that you have the capacity to pay your loan. In this modern day, you will not see anyone who is willing to lend you money without interest unless he or she is a family member or a close friend of yours. The longer you take to repay the debt and the higher the interest rate on the debt, the worse the debt. Credit card debt is the most common example of this kind of debt.
Good debts tend to have lower interest rates while interest rates for bad debt tend to be higher. If the installment amount exceeded may be half of your regular income, it’s a sign that is too much for you to bear. It’s hard to imagine a big chunk of your salary is being used to pay debt. Due to inability to pay off debts on time, the consequence is you will lose zest in life and inspiration to continue working.
Formal financial resources versus loan sharks
You may borrow from a friend as he or she will not take advantage of you by charging high fees or interest rate. However, it’s important to pay on time before unfulfilled obligation ruins the relationship when you take advantage of trust.
In some cases, it’s usually best to take a loan from formal financial resources such as banks and cooperatives. Formal financial institutions usually offer the best rates available in the market and are subject to strict regulations. This way, you can take advantage of lower interest rates and establish your credit history.
Bad debt is usually offered by an unregulated lending company like loan sharks who refuse to give information, such as the interest rate or how much money you owe. Loan sharks often target financially distressed or low income individuals, tourist or aliens who don’t have proper visas and desperate people who need money due to emergency situations. Aside from using threats or harassment to recover debt, they usually charged borrower with unreasonable high interest rate and other hidden fees.
Borrowing money can either be a blessing or burdensome for anyone. The bottom line is you are able to analyze if you can afford the loan payment structure. While it’s great to spot the types of debt whether good or bad, determination and sacrifice would certainly make the difference.
To avoid bad debt, it’s non-negotiable to have comprehensive insurance and an emergency fund. If you find yourself in bad debt, don’t be discouraged. Set you plans and commit to achieve your financial goals in a specific time. After all, one of the most important factors in the quest for financial freedom is to completely eliminate bad debt.