Debt is a reality for most people, whether it’s a mortgage, a student loan, or credit card balances. But not all debt is created equal. Some forms of debt can be considered “good” because they help improve your financial situation over time, while others are “bad” due to their high interest rates and lack of long-term value.
Knowing the difference between good and bad is crucial to maintaining healthy finances and achieving financial goals. In this guide, we’ll explore these concepts in simple terms, helping you navigate the confusing world of debt.
What is bad debt?
Bad debt typically refers to any type of borrowing that drains your finances without adding lasting value. This often includes high-interest debt, such as credit card balances or payday loans, which can spiral out of control if not managed carefully. The problem with bad debt is that it doesn’t help you grow financially – instead, it tends to eat away at your income, leaving you with little room to save or invest for the future.
One of the most common forms of bad debt is credit card debt. Equifax explains ‘bad’ debt as using a credit card to fund a holiday as it’s a purchase that provides no long-term financial benefit. And with the average credit card APR (annual percentage rate) at 35.61%, missing a payment or allowing your balance to build can lead to substantial financial strain.
Payday loans are another prime example of bad debt. These are short-term loans with extremely high interest rates and it’s not uncommon for them to have an APR of 1,500%, making it difficult for many borrowers to escape the debt trap.
Does bad debt affect your credit score?
Yes, bad debt can have a significant negative impact on your credit score. Your credit score is a key indicator of your financial health and it’s something lenders look at when deciding whether to give you a loan or extend credit. If you’re carrying large amounts of bad debt, particularly on high-interest credit cards, it can quickly lower your credit score.
High balances on credit cards or other forms of bad credit can increase your credit utilisation ratio (the percentage of your available credit that you’re using). A high credit utilisation ratio signals to lenders that you might be financially stretched, which can lead to lower credit scores. Additionally, missing payments or paying only the minimum amount can further damage your credit.
If you’re struggling with bad debt, debt solutions such as an Individual Voluntary Arrangement (IVA) can help you manage your payments which could improve your credit score over time.
What is good debt?
Good debt, on the other hand, is borrowing that helps you invest in your future and build wealth. It’s typically considered “good” because it has the potential to generate long-term financial benefits. Examples of good debt include mortgages, student loans, or borrowing to start a business. In these cases, they money you borrow is being used to acquire something of lasting value that can increase in worth over time or improve your earning potential.
For instance, taking out a mortgage to buy a home is often considered good debt because property values tend to appreciate over time. Even if the housing market fluctuates, the long-term value of owning a home generally outweighs the cost of the loan. Similarly, student loans can be considered good debt if they lead to a higher earning potential and a stable career.
However, it’s important to remember that even good debt must be managed wisely. For example, taking on too much student loan debt without a clear plan for repayment can lead to financial stress.
How to use good debt
Good debt can be a powerful financial tool when used correctly. The first rule of thumb is to borrow only for things that will increase in value or generate income over time. Here are a few ways to use good debt wisely:
1. Mortgage: A mortgage is one of the most common examples of good debt because homes typically appreciate over time. However, it’s important to ensure that the home you’re buying fits comfortably within your budget. Use a mortgage calculator to determine how much you can afford and aim to keep your housing costs at around 25-30% of your monthly income.
2. Responsible credit card use: While credit cards are typically considered bad debt, using them responsibly can work in your favour. For instance, some individuals use low-interest credit cards or cards with rewards programs for business expenses or to invest in income-generating activities. The key is to avoid carrying a balance, as high-interest rates can quickly turn this into bad debt.
Good debt should be seen as a tool for building financial stability, but it requires careful planning and management. For example, if you’re looking to restructure existing debt or consolidate loans, a debt consolidation loan could simplify your payments and potentially reduce your interest rates.
Managing your debt: How to turn bad into good debt
If you find yourself struggling with bad debt, it’s not too late to turn things around. Managing debt effectively can help you regain control of your finances and improve your financial health.
Here are some strategies to turn bad debt into good debt:
- Debt consolidation: Consolidating multiple high-interest rates into a single, lower-interest loan can make your debt more manageable. A debt consolidation loan simplifies your payments and could reduce your overall interest, making it easier to pay off your debt.
- Restructure your debt: If you’re overwhelmed by debt, consider speaking with a financial advisor about restructuring your debt through an IVA. An IVA is a formal agreement that allows you to pay back your debt over time while potentially freezing interest rates.
- Debt repayment methods: Using strategies like the Snowball or Avalanche method can help you tackle your debt in a structured way. The Snowball method focuses on paying off the smallest debts first, while the Avalanche method targets the debts with the highest interest rates.
- Break bad financial habits: Debt can sometimes stem from poor spending habits. Learning to recognise and break bad financial habits is crucial in avoiding future debt and improving your overall financial wellbeing.
By taking proactive steps to manage your debt, you can reduce financial stress and create a more secure financial future.
Not all debt is bad, but it’s important to understand the difference between good and bad debt and how each impacts your financial health. By using good debt wisely and managing bad debt effectively, you can work towards greater financial stability and long-term success.
Concerned about your debt? Visit MoneyHelper for free advice and debt information. Alternatively, get in touch with us and we’ll be happy to help you out.
