Home Wealth Personal Finance What’s the difference between good and bad debt?

What’s the difference between good and bad debt?

There's a simple equation.

Senior Digital Journalist, Your Money

Editor’s note: The following article contains information only. It is not intended as general or personal advice. Your Money recommends seeking professional advice specific to your personal circumstances.

There are many terms used to describe debt, from leveraging to gearing, credit, mortgages and loans.

At the end of the day it’s all about borrowing money, but is there such a thing as good and bad debt, and how do you tell the difference?

According to financial coach Rebecca Pritchard of Wealth Enhancers, there’s a very simple equation to it.

“If you’re borrowing money to pay for things that are going to go down in value or you’re going to consume… that’s bad debt,” she told Your Money Live.

That includes taking on debt for the sake of holidays, eating out, clothes, shopping or other lifestyle expenses.

“If you can’t afford to do this, don’t do it. If you don’t have the money in your bank account, then either find a way to get creative or prolong it until you need it.”

The fallout of getting into bad debt is that it’s always followed by a debt regret hangover, says Pritchard.

“You feel fabulous when you have the holiday or you buy the car…it feels fabulous up front, but then you do have to repay it.”

But she says there is such a thing a good debt, and when used appropriately, it can help to make positive life changes.

Pritchard describes good debt as when it’s used to purchase an asset that is going to go up in value or something that a person would never have access to without borrowed money.

The most common example of good debt is purchasing a property but it also includes education, business investment and even shares.

“Whilst [buying shares] might give a few people heart palpitations, it’s actually quite a common strategy. It’s very similar to borrowing money to purchase a property.”

Bad decisions

However, not all loans taken out for good reasons convert into good debt.

Timing in the market, the cost of the loan and personal financial financial circumstances all come into play.

“That’s why we need to understand what we’re doing, why we’re doing it and what it’s going to give us. Not just going out and taking on debt.”

For example taking out a mortgage without the ability to meet repayments should interest rates increase is an example of bad debt.

“Because right now, interest rates are cheap, but you can guess which direction they’re going to go in in the future, and that is up.”

Always be careful

Changing circumstances in the market, the economy and personal life can change a person’s financial situation very quickly.

For this reason, debt should never be taken lightly, Pritchard warns.

“The nature of debt means that we amplify things. So when we’re doing good things, debt can amplify it. So we have access to higher returns because we’ve leveraged ourselves.”

On the other hand, it can also make a bad situation far worse.

“So if you’ve borrowed money to purchase shares, that’s fabulous when the market’s going up, but you have to be prepared for when the market swings the other way.”

“It’s about making sure you’re not leveraged up to your eyeballs. Only borrow what you really can afford [and] maintaining a level of liquidity, so always having some cash in the bank so that you’re prepared if the unforeseen happens. ”

Tips to manage debt

Pritchard says it’s all too common for people not to have a good understanding of their debt.

To effectively manage debt, there are a few questions she says you first need to ask yourself:

  • How much do you owe?
  • How expensive is it?
  • When does it need to be repaid?
  • Are there minimum repayments or other rules?

After that she says debt products can be ranked in order from top to bottom priority.

“Generally speaking you want to pay off the most expensive debt first. The one’s that have the highest interest rates or the highest penalties first.”

From there, she says it might be worth getting rid of any smaller amounts that can be easily wiped clear.

Once the priorities are set it’s as simple as automating your cashflow.

Watch the video above for more tips.

Read more: 3 steps to manage your cashflow
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