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How to Tell the Difference Between Good and Bad Debt

While some debts can cause financial hardship, other debts are considered more healthy borrowing. How can you distinguish between a good debt and a bad debt to take on?

Debt is often viewed as a negative, with many debts causing financial worry and hardship. There are also some good debts which can improve your financial situation, when managed responsibly. 8.9 million UK citizens have borrowed more due to the global Coronavirus pandemic, according to the Money Statistics Report for this year, which means that many of us are in debt. How do you distinguish between a good debt and a bad debt to take on?

What is a good debt?

Good debt, or healthy borrowing, are items which can be used either to generate more income or to invest in essentials or valuable assets. A good question to ask yourself when considering whether something is good or bad debt, is: will it improve my personal finances in the long term?

Sometimes debt may even be good for your credit score, provided that you can afford the payments and always make them on time. This helps lenders to view you as a responsible borrower.

To be considered a good debt, the debt must have:

  • Affordable repayment and interest terms;

  • Lasting value, for example it will increase your wealth in the long-term, or is an essential item

Examples of good debt

Some examples of good debt that many people take on are:

  • Business loans – many small businesses rely on borrowing in the form of business loans;

  • Home mortgages – most people require a mortgage when buying a home;

  • Student loans – many students borrow to fund both their university education and living costs while they are studying. The average full time maintenance loan borrowed by students in England increased by 5.1% in the last academic year, according to the UK government’s National Statistics on Student Support for Higher Education in England 2020.

Saving instead of borrowing

While some borrowing can be healthy, saving money to use to fund these long-term investments is also important. As per the UK Savings Statistics 2020, an average UK citizen saves around £105.43 every month. If you can pay for the items that you need without taking on any debts this is usually preferable.

Things to consider before taking on good debt

When you consider borrowing any money, you should consider the interest rate and bear any high interest rates in mind to make sure that you can meet the monthly payments. The interest rate is the percentage that is charged on the principal amount which is borrowed from the bank. As per the Bank Rate UK, the interest rates might vary from 5.5% to 7.5% based on the bank and the credibility of the borrower and can even increase in some cases.

You should always check your financial health before borrowing money. If you have a poor credit score, this is likely to impact your chances of accessing a loan or other financial products. This is because lenders view credit history as a clue to your future loan repayment habits.

When thinking about whether to borrow money, evaluate your monthly income and expenses and make sure you plan for the long term before making the financial decision.

What is considered bad debt?

Generally speaking, bad debt is when the money borrowed is for items that do not have lasting value or when keeping up with the payments is unachievable.

An example of this is payday loans, which may often have high interest rates and quick turnarounds to pay back the loan. In the short term, payday loans may seem like a way to solve problems affording essential and non-essential items, however this solution can often add additional debt. Additional charges can sometimes be added if you miss repayments or pay late.

Alternatives to bad debt

One of the alternatives to taking on unaffordable loans is a debt consolidation loan. Debt consolidation loans can be used to consolidate your debts, such as credit cards and payday loans, into one affordable monthly payment that you are able to pay back.

Although consolidation loans have interest, for some people they are a better alternative to taking on bad debt because the repayments are calculated based on affordability.

Debt consolidation loans may be an option even for those with a poor credit score and in some cases, debt consolidation loans may also improve your credit score if you make the correct repayments on time.