Debt. We know it’s not exactly a thrilling topic, but the lack of knowledge is a recipe for disaster. It’s essential to understand the difference between good debt and bad debt to take control of your finances.
In fact, 70% of Filipinos are stressed because of debt. But of course, we’re not here to bore you with financial jargon. While it’s impossible to live without debt, the least we can do is minimize it. Let’s simplify good debt vs bad debt with examples in this article.
Overview of good debt and bad debt
|Good debt||Bad debt|
|They help you build assets and wealth||They are not considered investments|
|They increase in value over time||They often finance consumables|
Let’s start with good debt — yes, that’s right, good debt actually exists. This refers to any debt you take on that has the potential to increase your income or boost your net worth in the long run.
Conversely, bad debt is any debt that doesn’t contribute to your long-term financial goals or, worse, actively works against them. Debts like these can be a slippery slope, leading to growing interest payments. They hinder your savings, investments, and long-term wealth building.
Examples of good debt
Examples of good debt are debts that positively impact your financial growth and are usually used to invest in something that will increase in value.
|Good debt||Bad debt|
|Mortgage||High-interest credit cards|
|Student loans or school loans||Personal loans for discretionary items|
|Car loans||Payday loans|
A mortgage is a loan designed to help you purchase a house or property. This is a good kind of debt because it allows you to build equity in your home over time while also enjoying the benefits of homeownership.
Plus, when you sell your home, you’ll likely make more money than you initially paid for, especially if it’s in a prime location. Imagine that. It’s like hitting the jackpot.
Your parents took out a mortgage to buy your childhood home. Then they took advantage of low interest rates. As they paid off their monthly mortgage, they built equity in their home. When they sold it, they made a profit because its value was appreciated.
Take action: If you’re buying a property, increasing your downpayment or equity up to 50% is best to get favorable interest rates and monthly payments. In addition, if your monthly payment is too high, try downsizing, refinancing, or moving to a low-cost area with manageable payment terms.
Student loans or school loans
This type of loan helps students pay for their education expenses like tuition, books, and living expenses.
This is a good kind of debt because it can help you increase your earning potential in the future. The more education you have, the more money you can earn in your chosen career.
For example, a friend took out a student loan for their engineering degree. Because of their education, they could get a job as an engineer with a higher salary than they would have without a degree. On top of that, they can pay off that loan much faster because of the increased earning potential.
Take action: Try applying for a scholarship before getting a student loan.
Last but not least, let’s talk about car loans. This is a type of loan that helps you buy a car. This may be a good debt because it can help you get to work and achieve your financial goals, such as getting a better job or starting your own business.
When your uncle took out a car loan to buy a vehicle for his delivery business, he can deliver more products and earn more money with his new car. Within a year, he was able to pay off his car loan and still had extra money to save for his family’s future.
Remember, though, that a car loan can be a double edge sword in your finances. Maintaining a car also requires you to shell out money. So, ensure it’s used for achieving financial goals or building a business, rather than just posting it for the ‘gram.
Take action: If the monthly payment is too high, better trade it for a functional yet affordable car with manageable terms.
Examples of bad debt
Identifying bad debt can be tricky, especially if you’re not checking the lender’s terms and conditions. It’s the kind of debt that can derail your financial goals. Let’s explore some examples to help you recognize and avoid them.
High-interest credit cards
First off, high-interest credit cards are a common kind of bad debt. They often have interest rates of 20% or higher, which means that as time goes by, you’re paying more and more money in interest rather than towards your actual debt.
So, what makes this a bad kind of debt? It’s simply because you’ll likely keep paying more than your actual balance if you aren’t careful. Instead, opt for credit cards with lower interest rates or pay using debit cards to avoid overspending.
Take action: If you have accumulated credit card debt, try controlling your spending and paying your debts using the snowball method. You may also balance transfers to other credit cards with lower interest rates.
The second example of bad debt is personal loans for consumables or discretionary items. What does this mean? It means you are borrowing money to buy things you don’t necessarily need, such as a high-end gadget, a luxurious handbag, or a vacation.
While we all need a little splurging here and there, borrowing money is essentially trapping yourself in a financial rut. This is bad debt because you will pay interest on an item with no real financial or practical value in the long run.
Take action: Consider setting aside a specific amount each month to save up for your discretionary purchases. Better yet, pay cash to get more discount.
Payday loans typically offer quick cash with short-term payment terms. Sounds good? Wrong. Payday loans often have steep interest rates, and the short-term payment period can quickly become a financial burden.
What makes this a bad kind of debt is you can get caught in a cycle of borrowing and repaying, which often leads to much more debt. A great alternative is to save emergency funds that can serve as a buffer against these unexpected situations.
Take action: Consider refinancing if you’re already in debt with high-interest rates. If you need funds, you may also seek help from family and friends.
Debt is considerably good when you use it as leverage to build wealth. However, swiping credit cards mindlessly and purchasing consumables and discretionary items can spiral out of control, leading to bad debt.
It’s not yet too late to make moneysmart decisions regarding managing debt. However, it’s even more beneficial to reduce your exposure to it as it also lessens risks.
What do you think of the examples of good debt and bad debt mentioned above? Let us know in the comments below.