You’ll often hear that ALL debt is bad debt and that you should never have any debt. This may seem reasonable, but is it? The reality is that most of us will have to take out some form of debt in our lives. Most consumers don’t have access to funds to make large purchases such as homes or vehicles. Similarly, most entrepreneurs or small business don’t have financing to fund their businesses. Debt is required in these circumstances. Let’s look at which debt is considered “good”.

Basically, one can categorize debt into two groups, good debt and bad debt. The principles outlined below will help you to decide which category your current or future debt falls under.

What are considered “Good” debts?

Let’s start with the good debt. Debt that is used to create more value is known as good debt. A business might need a loan to buy equipment, a premises or other assets which allow them to earn revenue. A consumer may need to buy a vehicle in order to get to and from work, which allows them to make money. Owning a home can create value and most homes are bought with a bond. It normally takes 20-25 years to pay off a bond. Homeowners generally realise an increase in property value over time or can now rent it out for extra income.

Some people take out loans to invest in other companies, which they believe will increase in value. The intention of these debts is to increase and create extra value. There are always risks associated with these loans as well, as not all investments appreciate. The business could fail, tenants may not pay their rent or you may have an accident and not have comprehensive insurance on your car. You also may buy property at the wrong time in the cycle or the sentiment of the area decreases.

What are considered “Bad” debts?

The more common debt category is that of the bad debt. Unnecessary shopping or luxurious purchases are the most common types of bad debt. These debts add no value. They may make you feel happy for a short while, but essentially, they cost you lots of money. Taking out a loan to buy new clothes, or a new TV, or to go on a holiday may not be a good idea. Items bought with a loan actually cost you more than the item itself after the fees and interest of that loan. It is possible to sell the clothes or the TV but it will be for less value than you paid for it and you would have made a loss.

If short-term unsecured debt can be easily repaid, then it may be a viable option. However, unsecured debt usually has higher interests rates and therefore the cost of borrowing can be high.

Always consider the cost of new debt

Before applying for a new loan, store card or credit card, check the terms and conditions. Make sure you understand the interest rate and other fees. Unsecured debts usually have interest rates of between 20-32% per annum. This is the cost you pay to borrow the money to buy specific items and pay for services.

Using lots of debt often can land you in a debt-cycle, where you find yourself using debt to pay off other debts each month. This can be dangerous for your finances in general.

What can you do if you have a lot of bad debt?

Try avoiding using debt for day-to day expenses and try to budget. Budgeting will help you afford the lifestyle your salary allows and can help you to save. Instead of buying something with a loan or on credit, try saving up for a few months. After a period of time you may be able to afford the item using cash.

If you already have too much debt and have fallen into the bad debt trap, contact a debt counsellor who can help you to reduce your debt payments and save you money. Debt counsellors offer a range of debt services based on your financial situation and they can help you to make the wise choice and get debt free as fast as possible.