What is Good Debt?
Owing people money isn’t something with very many positive connotations. Most readers will be hard-pressed to think of a time when they were happy about being in debt or excited about paying it off. It seems then, that the phrase ‘good debt’ must be some sort of oxymoron. Like a ‘deafening silence’ or a ‘cold sweat’, the term seems to contradict itself, after all, how can debt be good? Surprisingly, this isn’t some sort of mistake, experienced financiers will often talk about good debt and the various benefits that it can afford. But what does this really mean? What is good debt? How does it compare to bad debt? And how can you tell the two apart? What is Good Debt?
Good debt is a term used to identify debts that have some chance of positively impacting your finances in the long run. In other words, while debt is normally seen as a negative, you can occasionally go into debt for quite good reasons which may eventually make it worthwhile.
If this is all still a bit fuzzy, that’s OK – there are other ways of looking at it. Maybe, the easiest way to understand good debt is to look at some examples that you may come across in the real world.
What are some Examples of Good Debt?
Good debt doesn’t only occur when an asset increases in monetary value, sometimes it involves investments that grow your funds in other ways.
|Student Loans – Perhaps the most common form of debt can be seen when people take out student loans in order to invest in their education and training. At first, this may seem like a mistake because you don’t immediately reap the benefits from your pursuits, but, over time, those advancements might land you a much more lucrative job than you would otherwise have been eligible for, thus making the original loan a type of good debt. It should be noted, however, that different types of education pay different dividends. In other words, you need to make sure that the degree or training that you seek is going to pay the bills once you obtain it.
|Mortgage Payments – Property has a habit of increasing in value over time… usually. As a result, many people are able to grow their money simply by buying a home and living in it for a few years. Additionally, the property can be rented out to others which can end up creating a whole new source of revenue. You might incur a massive amount of debt when you first buy a house, but, over time, you may end up making quite a sizable profit from it as well. Once again, this kind of investment isn’t without risks and buying property isn’t always an example of good debt.
|Business Loans – You may need to borrow some serious capital if you want to get your very own business underway, however, the rewards may be well worth the risk if you’re able to build a profitable enterprise. It must be said that this is probably the most dangerous of the ‘good debts’ that you can get yourself involved with. Many businesses fail before they can start making money and usually, the funds that are required to get started are pretty steep. That said, a loan that enables you to create a flourishing business can definitely be described as a type of debt.
What is a Manageable Amount of Debt?
Obviously, it’s hard to see the ‘good’ in ‘good debt’ when the amount of money you owe reaches an excessive level. This begs the question, how much money owed is appropriate and how much is too much?
Because everyone’s finances are different, we normally don’t use a fixed number to determine what is manageable. Instead, it’s more useful to consider your Debt-to-Income Ratio (DTI) and go from there.
Your DTI is just the percentage of your gross income that goes into paying your debts each month.
In other words, a person who makes R100 per month and has to use R60 of that to pay his debts would have a DTI of 60%.
Opinions differ as to what level of DTI is best with many groups arguing that anything under 35% is ideal. It must be noted, however, that South Africa’s debt averages have been suffering badly in recent years which makes it particularly difficult to pinpoint an exact amount. All in all, it’s best to keep that percentage as low as possible as high rates are going to make it harder for you to receive loans.
Good Debt vs Bad Debt
Now that we’ve covered good debt in some detail, it may be wise to consider what we would call ‘bad debt’ and learn how the two can be distinguished.
*Bad Debt comes from purchases that do not benefit your finances and that tend to shrink in value as time goes by.
Bad debt is usually associated with frivolous and unnecessary spending and can commonly result from impulse buying.
A great example of bad debt would be a person with a meagre income taking out a loan in order to buy designer shoes. The shoes weren’t needed and they probably won’t end up turning a profit.
*It is worth mentioning that this definition only applies when used to contrast ‘good debt’ and that the term ‘bad debt’ can also refer to loans given by creditors to people who can no longer pay them back.
What are the 5 C’s of Credit?
Before you get yourself in debt, it’s probably best to consider how you will be evaluated by lenders. You may have heard of this term before – The 5 C’s of Credit. This is a system used by lenders to help determine your creditworthiness
By checking the 5 C’s of credit, a lender will be able to figure out if loaning you cash would be a safe bet or not. The 5 C’s are –
- Capital – How much money do you have?
- Capacity – Do you have the ability to pay back a loan? (This mainly involves looking at your DTI)
- Character – What is your credit history? (How long have you been taking out and repaying loans for? How frequently do you miss payments? Etc)
- Collateral – What kind of assets do you have which can be collected if you cannot make your payments?
- Conditions – What are the specifics of the scenario? (How much money do you want to borrow? What do you want the money for? Etc)
What is Healthy Debt?
Healthy Debt is another name for Good Debt. It refers to debt that is taken out in order to grow your wealth and benefit your finances over time.
Healthy debt can be used to contrast ‘unhealthy debt’. The latter is normally characterized by unnecessary loans which are taken out to purchase depreciating assets. An example of healthy owing of money may be seen in certain home loans. The loan allows you to buy a house which then increases in value.
On the other hand, unhealthy owing of money may involve taking out a loan to buy an expensive sports car. The car is not a necessity and it begins to lose value from the moment it is purchased.
In Conclusion – What is Good Debt and What are Some Examples?
A person experiences good debt when they take out a loan which will grow their money or provide some sort of profitable asset in the future. Even though the individual owes money, they will likely make it back via their investment and thus the money that’s owed can be called ‘good’.
Examples of good debt include things like mortgages and business loans and can even apply to less tangible benefits such as educational advancements. This classification, however, can shift depending on the nature of the investment and the context in which it is made. In other words, a home loan or a business loan could be an example of ‘bad debt’ if it does not yield profitable results.
On the other end of the spectrum, we encounter bad debts. These are usually apparent when individuals take out loans in order to make purchases that will not benefit them financially. If, for example, you go into money owed in order to buy a new sports car, we would normally classify it as bad debt because the car was not a necessary purchase and it is unlikely to grow in value.
There is no particular amount of money owed that is considered to be good or appropriate as everyone’s financial situation is different. For this reason, we normally focus more on a person’s credit-to-Income Ratio (DTI) to provide us with a more accurate measurement. The lower your DTI, the better your position will be regardless of the actual amount you incur. It should be noted, however, that South Africans usually experience much higher DTI levels than various other countries, and thus, the context has to be considered when working out what a healthy DTI would look like for you personally.
Disclaimer Finance101: All of our posts are for research purposes only. Finance 101 aims to assist its readers with useful information on the laws of our country that can guide you to make financial decisions that will enable you to become more financially independent in the future. Although our posts cite the constitution in many instances, they are intended to assist readers who are looking to expand their knowledge of the law & finance-related queries. Should you require specific legal/financial advice we advise you to get in touch with a qualified financial expert.
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