The Difference Between Good and Bad Debt

Many people view debt negatively, due to the financial worry and difficulties caused by bad debt. However, some debts are good debts which improve your financial future if they are well managed. According to this year’s the Money Statistics Report, 8.9 million citizens in the UK have borrowed more due to the current COVID-19 pandemic. How do you tell the difference between a good and bad debt?

The definition of a good debt

Items which can increase your wealth or are an investment in an essential or profitable goods can be seen as good debt to have. When considering whether a debt you are about to take is a good debt vs a bad debt, ask yourself whether it will increase your wealth or improve your standard of living in the long term rather than just the short term.

Good debts may actually benefit your credit history, if you pay the agreed repayment on time and in full. This builds a picture of you as a trustworthy borrower for lenders to lend to.

To define something as a good debt, it should be:

• Affordable in terms of the interest and payments;
• Have a long-term benefit, for example it is an essential debt or will improve your personal finances in the long term

Good debt examples:

Some examples of common debts that might be considered as good debts are:

• Business loans;
• Home mortgages;
• Student loans

Business loans are often essential to start up your business if you do not have the capital to do this without. Business loans should be expected to increase your overall wealth in the long term due to it being an investment in a profitable scheme.

Home mortgages are often required for people to purchase their first home, as increasingly people do not have the capital to buy their own homes outright.

Similarly, a lot of students in the UK do not have the funds to pay for their living costs and tuition fees upfront so may require a student loan. According to the UK government’s National Statistics on 'Student Support for Higher Education in England 2020', the average full time maintenance loan borrowed by students in England increased by 5.1% in the last academic year.

Save where you can

While some debts are healthier than others, it is also crucial to save money to fund essentials and long-term investments so that you can spend without borrowing. According to the UK Savings Statistics 2020, an average UK citizen saves around £105.43 every month.

What to consider before taking on debts

When you consider taking on any personal debt, even those described as good debts, you need to consider the interest rate and monthly repayments to make sure these are affordable for you. Interest rates are the percentage that is charged on top of the initial amount borrowed.

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 take your financial outlook into account before taking on any new debts. Consider whether your credit score might be likely to increase the interest rates on a debt – people with poor credit history may experience increased rates of interest because lenders use your credit score as a way of predicting your future behaviour and ability to pay back loans.

You should also always consider your monthly income and outgoings before borrowing money. Always plan for your long-term financial health before making the decision of whether to take on debts.

What is bad debt?

Bad debt is typically classified as debts which are unaffordable or where the money borrowed is for items that do not have a long term value. Payday loans, which have high rates of interest and usually short term repayment dates, are an example of bad debt. Although payday loans can seem like an easy and quick solution to issues affording both essentials and additional items, this option often leads to extra debts and affordability problems.

Additional costs can rack up if repayments are missed due to the debt being unaffordable.