Money Management: Good Debt Vs Bad Debt
Think no debt is a good debt? Think again. You may be missing out on the financial benefits of debt financing. Just because you have credit card bills or a business loan to repay doesn’t necessarily mean that you have a bad money management issue. On the contrary, taking out a debt can be a smart financial move.
A loan does more than just helping you pay for something that you can’t otherwise afford, like buying a car or a house or starting a new business. It also helps you grow your wealth and improve your life.
What Is Debt?
Debt is any amount of money that you borrowed from an individual or organization. This is under the condition that you will pay back the money at a later date, often with interest.
Several types of debt include:
- Loan - Has to be repaid over some time along with the interest that it carries
- Mortgage - A loan that typically takes out any valuable property as collateral
- Credit Line - A revolving debt that allows you to borrow against an established credit limit regularly
- Lease - A contract that allows you to use an asset for a specified time in return for a periodic payment
Debt in and of itself is neither bad nor good. It is the circumstance under which it is acquired that makes it the root cause of financial problems or financial security.
What Makes a Good Debt?
Borrowing money to spend on something that will grow in value or help you make more money and increase your net worth constitutes a good debt. It helps you improve your financial situation and achieve your financial goals.
The most common examples of good debt include:
It is a smart move to borrow money to start a new business, keep your company afloat during hard times or take your business to a new level of growth. Like most businesses, you may not have enough working capital to support a smooth operation or you may not be earning enough profit yet to buy new equipment and commercial vehicles. Without the extra funds, financing all these projects is impossible.
- With a small business loan, you’ll have the money you need to finance all your business needs.
- As a result, the efficiency and productivity within your company increase.
- This results in an increased profit, improved employee morale and attitude and better customer service.
2. Home Loan
Everyone needs a home of their own, especially families, but only a few can afford to buy a new home with cash. By taking out a loan, you can buy your home and make periodic payments until you can repay until you can satisfy your debt.
Taking out a debt to buy your own home is usually through a mortgage loan or a home equity loan.
- A mortgage loan is an original loan that you take out to purchase your home.
- A home equity loan, meanwhile, is a financing option that you can get if you have equity in the property. It is usually intended to fund home improvements, repairs and maintenance. The money that you borrow is secured by the equity in your home.
Both mortgage and home equity loans allow you to borrow money from a lender to buy the home. However, you are required to pledge your home as collateral for the loan, which means that the lender can foreclose it if you fail to keep up with your payments.
A home loan is a good debt because you can purchase an asset with several tax benefits. You can also turn your home into an investment if you decide to sell it after several years.
3. Student Loan
While it may take you several years to pay off a student loan, it is generally still a good debt to get because it helps you get an education and earn a degree. If an Australian student, there are government loans that you can take advantage of including:
- HECS-HELP - Available for students who are enrolled in Commonwealth-supported place; Covers only your student contribution but not the costs of your accommodation, laptops and textbooks
- FEE-HELP - Allows you to pay all or part of your tuition fees; Only for students who are not enrolled in a subsidised place
- SA-HELP - Helps you pay your student services and amenities fee (SSAF), which is charged yearly in universities and higher education providers
- OS-HELP - Enables you to pay your study expenses overseas if you enrolled in a Commonwealth supported place and want to take some of your courses abroad
Taking one of these student loans to finish your studies is especially worth it if you land a well-paying career. The highest paying professionals in the country include doctors, lawyers, engineers, accountants, and IT architects and managers.
What Are Bad Debts?
Bad debts are not created by borrowing money to purchase depreciating assets but greatly help your personal or business life. A car, for instance, decreases in value the moment you drive it off the dealership but it can also provide tremendous help to your transportation needs, especially if you’re running a business.
Rather, bad debts constitute all the financing that you acquired despite not having enough income or profit to make monthly on-time repayments. These financial decisions do not help generate income and may even put you under tremendous financial burden.
The most common debts that often lead to financial loss include:
1. Informal Moneylenders and Loan Sharks
Informal lenders are usually individuals who lend money to their peers and acquaintances and run their “business” through words of mouth. They are not licensed to provide any form of financing and they do not report to the credit bureaus. Even if you make on-time payments, this won’t have any positive effect on your credit score because your payment activities are not reported.
- Many of these lenders are considered loan sharks because they target people who have bad credit and may not have the capacity to repay a loan but are desperate to get financing. They usually issue small loans at an exorbitant nominal interest rate of 20% or more within short credit terms. They may also collect payments on a daily or weekly basis.
- While borrowing money from an informal lender can help you get funds without little or no collateral and documentation needed, it often leads to a debt trap. Aside from the high-interest rate, loan sharks usually charge a flat fee equal to a certain percentage of the amount you borrow. They also charge high fees if you can’t keep up with your repayment schedule.
2. Payday Loan
A payday loan, also called cash advance loan, allows you to borrow money without any credit check. However, it is secured against your paycheck. You will have to repay the loan with interest on your next pay. Generally, you will give the lender a Continuous Payment Authority (CPA), which allows them to automatically take the loan amount with interest directly from your bank account on the agreed day of repayment.
- While securing money from a payday loan is very convenient, its interest rates are impossibly high. Lenders often charge interest of $15-$20 for every $100 borrowed. The annual percentage rate typically cost 400% or more.
- Also, if you fail to pay back the amount by your next payday, you will be charged with a late payment fee. Your loan will also continue to attract a daily interest of 1%. You will live in a neverending treadmill of financial stress.
3. Borrowing within your superannuation fund
Your superannuation fund is meant to be used in your retirement years. Keep it that way!
While it is generally prohibited to access super fund contributions before retirement, you can gain early access to your contributions if you are in financial hardship, need immediate financial assistance for medical or death-related expenses, temporary or permanent incapacity and terminal medical condition.
If you are a member of a self-managed superannuation fund, you can also borrow money from your Super fund to purchase a single asset or a collection of identical assets.
- However, borrowing money from your retirement fund is usually a dumb move. Aside from the penalty charges and taxes, you will also take money away from your future.
- Remember that the money in your superannuation fund is invested in a range of assets. If you take this money away, you will not earn investment returns.
Debt Financing is Part of a Healthy Money Management
It is possible to live debt-free, but it is not a smart financial decision, especially if you want to build your wealth and secure your financial future. To fund a personal or business endeavour, you need to have funds. Taking out a loan makes this possible.
By getting a loan and making on-time repayments, you are also building your credit score. This improves your creditworthiness and increases your chances of securing a loan for future personal and business endeavours.
Improve your financial situation and achieve your financial goals with good debts. At Positive Lending Solutions, we offer different loan products for your different needs. To get a loan with the best interest rate and terms, call us on 1300 722 210 or request a Quick Quote.