For certain expenses such as purchasing a car or investing in a new business, you need large amounts of sums. Borrowing money from banks and financial institutions is the only option to fulfil your needs. But, acquiring loans puts you into financial debt. However, not all debts put you under a financial load if you understand the notion of good and bad debts.
A loan with an aim of investment can generate wealth and make you financially healthy. On the other hand, borrowing money carelessly can degrade your credit performance and put you under bad debt. The article below acquaints you with the differences between good and bad debts and related aspects.
What is a Debt?
Debt is essentially a form of borrowing in which one party borrows money from another to meet their obligations or expenses. Debt is similar to a loan in most cases but not exactly the same. Corporations and entities use debt to make large purchases which otherwise is not possible in normal situations. In a debt-based arrangement, the lender allows the borrower to use the lent money on a condition that it must be returned to the creditor within the specified date and it includes a profit or interest rate. Debt can be classified into various categories such as unsecured, secured and mortgage loans. In broad terms, there are two types of debts namely: Good and Bad Debts, depending on the type of return.
What is Good Debt?
Good debt is one, when invested makes money further. In other words, the debt that generates income or builds your net worth can be referred to as good debt. Such borrowings can improve your financial well being in one or another way. Corporations and business owners take loans from banks and create assets that generate the revenue and profits both, the lender (in the form of loan repayments) and business owners in form of profits. Such loans are examples of good debts. Let’s get into the other examples of good debt.
What are the Examples of Good Debt?
Following forms of debts create income or increase the value of items purchased, hence referred to as good debt.
Mortgage: A loan taken to purchase a house, apartment or building to generate income forms a good debt. When buying a house, you build equity and it creates an income source. Apart from the growing prices of real estate, you can lease/rent your building increasing your profit margin. However, not all real estate investments are considered good debt. For example, You buy a house for personal use and due to reception, the real estate prices dip down. In such cases, the mortgage turns into a bad loan.
Student loans: With a student loan, you are increasing your income potential in the long run and, it justifies the need for borrowing. According to the statistics, individuals with a graduate certificate earn around AED 3.5 million more in their lifetime than a post-secondary certificate holder. However, student loans can turn into bad debt if you are unable to recover the cost of your education or get employed with adequate income. Therefore, you should limit the amount of loan depending on your requirements and capabilities.
Business Loan - The loan taken to start a venture or grow a business is known as a business loan. Such loans aim to grow wealth over time, so these are categorised as good debt. However, starting your own business involves risks similar to education loans and, they can also turn into bad debt. Businesses fail due to several factors but, with proper strategy and market research, you can increase the chances of your success.
Corporate Bonds - Corporate sometimes need to gather huge funds for their expansion. For this reason, they release corporate bonds that an individual can purchase and support the company in raising funds. When the company makes a profit post-expansion the bondholder receives a percentage as profit. Since the corporate bonds increase the net worth of the company with their positive performance, they are categorised as good debt. Depending on the company’s negative performance, it can also turn into bad debt.
What is a Bad Debt?
Investing into something that depreciates the value of purchase over time lands you bad debt. Meaning, a loan that is taken to buy liabilities that would eventually generate losses is known as a bad debt. Considering the fact that you need to repay your borrowings from your pocket, it is advisable not to go for a bad debt. Several good debts can also result in bad debt if the result is not profitable. Purchasing any form of liability or consumable item can be categorised as bad debt. A few examples of bad debt are as follows
What are the Examples of Bad Debt?
Any kind of debt that reduces your net worth or depreciate the cost of the item comes under the bad debt category. Following are examples of bad debt.
Credit Card Debt: Credit cards offer short term loans to meet your daily expenses. However, these loans include huge interest rates when paying them back. Additionally, with the amount of loan that credit cards offer, you can only purchase consumable items (liabilities). It eventually depreciates the value of your purchases and thus falls under the category of bad debt. Despite the tempting offers you get on your credit cards, you should check your spending habits. Using credit cards in the UAE for everyday purchases should be within your limit and intentional such as for earning rewards. For the amount you spend every month on the credit, you must be capable of paying them back within the due date.
Personal Loans - Personal loans are the source of urgent funds during financial emergencies. And, you must only keep them as your last option. Since in most cases personal loans do not generate wealth or your net worth, they are categorised as bad debt. Additionally, the interest rates on personal loans are one of the highest in the UAE. For these reasons, you should abstain from taking personal loans from banks or financial institutions until you gravely need financial assistance.
Cash Loans - Similar to personal loans, cash loans also incur huge interest rates. You can conveniently acquire credit card cash loans and via online/mobile financing applications by following a few simple steps. Since the cash loans are consumed in purchasing items with depreciating values, they come under the bad debt category. You may find a cash loan APR (Annual Percentage Rate) of 10% attractive but it can charge you up to 35% annual interest rate. So, it is crucial to understand the fine line while acquiring a cash loan. You should refrain from applying for cash loans and choose other available options.
Car Loans - The value of a vehicle depreciate with every passing year. In fact, by the time you leave the showroom, the vehicle depreciates by 10 to 20%. So, from a financial perspective, investing your borrowed amount on vehicle purchases falls under the bad debt category. In case you require a car, look for the lowest car loan interest rates, which can save you from paying hefty interest on your vehicle purchases.
Key Differences Between Good and Bad Debt
Following are the important differences between good and bad debt.
Good debt is always considered as an investment
Bad Debt is being taken against the purchase of liabilities
The value of things purchased against good debt increases over time
The value of things purchased against bad loans always decreases
Classifying good or bad debt is not easy for a few types of loans. Depending on your financial situation, some forms of debt can be beneficial for you on a personal level. Here are a few cases:
Borrowing for Investments - Investment in equities and stocks can make you money. If you hold a stock trading account with a brokerage firm, you can borrow funds from the margin accounts. Borrowing money to purchase stocks and security can gain you profit (depending on the stock performance). However, such borrowings are not viable for inexperienced investors because they have higher chances of losing money.
Borrowing to Repay Your Loans - Debt consolidation is a feasible option for individuals who are under credit card debts or personal loans. Borrowing funds from a bank or a financial institution to repay the debt amount can be beneficial. Debt consolidation loans have low-interest rates in comparison to credit card debts and personal loans. By consolidating their debts, individuals can save money with low-interest rates. However, they need to ensure that the amount they borrow must be used to repay the loan and not for other spendings.
How to Concentrate on Good Debts and Avoid Bad Debts?
Acquiring good debt depends on your financial planning, decisions and practices. The good and bad debts are based on the end results. If you achieve the purpose of acquiring your loan or mortgage successfully and gain value eventually, your debt is considered good. Here are a few ways to focus on good debt and avoid bad debts.
Acquire loans in cases where you can generate profit and increase your net worth. For example, when you take a student loan for a masters degree to increase your earning potential, you need to succeed with your degree and get employed. Once you get into a high paying job, your debt becomes good and you can repay your loans conveniently.
Avoid borrowing money to purchase liabilities. Since the value of your item depreciates over the period, you will only end up owning the bad debt.
Pay close attention to the amount of money you borrow. An excessive loan can put under bad debt and a huge financial burden. You need to keep a record of your income and expenses while applying for a debt. Additionally, you should keep your debt-to-income ratio well below 40%.
Whether the debt is good or bad, try repaying your borrowed money as quickly as possible. It allows you to generate income without worrying about debt repayments.
In general, good debts are the kind of borrowings that increase your worth and generate wealth. Mortgage, business loans and student loans are some of the examples of good loans. A good debt augments your financial wellbeing. An investment in liabilities is considered as bad debt and from a financial perspective, it should be avoided. With better financial decisions and practices, you can distinguish between good and bad debt to make better investments.