When people are given advice on debt, the common line of thinking is to avoid it – with familiar sayings like “save for what you want, then pay cash”, and general warnings of the pitfalls of lending.
However, not all debt is equal, according to credit reporting group TransUnion, which says that consumers should be aware of the difference between ‘bad debt’ – which can indeed land you in serious trouble – and ‘good debt’, which is sensible, well managed, and can help put you in a better financial position.
“In 2019 precious few of us can afford to pay cash for a home, a car, our tertiary education or even furniture. In fact, having credit is practically essential to navigating modern lifestyles,” said TransUnion director Garnet Jensen.
“The trick is to know the difference between good debt and bad debt, and managing your credit wisely.”
According to Jensen, the rule of thumb is that ‘good debt’ is debt that is a sensible investment in your financial future: it helps you generate an income, or increases your net worth, for example.
Some examples include:
- Student Loans: Investing in yourself can increase your earning potential – and those increased earnings can help you pay off the debt more easily.
- Real Estate: There are many opportunities to make money in the property market if you make smart decisions. A simple strategy is buying a home, renovating it and then selling it for a profit – or renting it out on a platform like Airbnb. Commercial real estate is trickier, but can offer good cash flow and significant capital gains.
- Car Loans: For many, a car is essential – it’s what gets you to work every day, and if you’re self-employed, it’s a key business tool. But be smart about it, warns Jensen: buy with your head, not your heart, or it could quickly become a bad debt that breaks your budget.
‘Bad debt’ is debt that drains your wealth and offers no prospect of paying for itself in the future – like vanity purchases that won’t help you generate income.
Typical ‘bad debt’ items include:
- Clothing & Consumables: Buying clothing on credit may seem necessary when you’re overhauling your wardrobe to start a new job, but dressing to impress can have a downside. “Clothing doesn’t increase in value and the interest repayments can leave your finances looking threadbare,” said Jensen. “Paying for a holiday, restaurants and entertainment with credit also has no material benefit – all the interest you’re paying could be used to pay for other, more necessary things.”
- Credit Cards: This is a convenient form of credit but is often accompanied by eye-watering interest rates. Credit card debt is one of the quickest entry point to a bad debt spiral if you don’t manage your payments properly. If you’re having trouble making ends meet, reassess your finances and try to budget smarter, rather than incurring debt that only increases exponentially with interest repayments.
- Micro Loans: A lot of people fall into the trap of taking out micro loans to get them through the month or pay unexpected expenses. These loans have extremely high interest rates, and should be avoided wherever possible.
Regardless of the type of debt, it’s important to manage it properly – being smart with your money isn’t about avoiding credit altogether, Jensen said.
“Good credit health is about meeting your obligations timeously to maintain a positive credit report. Any failure to keep up with your credit obligations can have a negative reflection on your credit report, which can have a longer-term impact down the line when it comes to securing credit in future.”