The concept of debt has always been regarded as something that any financially savvy individual should look to avoid. When confronted that Australian household debt reached $1.9 billion in 2022, you would be forgiven for thinking the outlook is pretty bleak.
Borrowing money haphazardly and taking on bad debt that will leave you financially vulnerable is never a good idea.
However, many forms of debt can be used to build wealth and increase your cash flow, resulting in robust financial health. If a debt is used in this manner, it is known as ‘good’ debt.
Let’s get to the following commonly asked questions:
It is often said that businesses just starting will need to borrow money to make money. Often it is necessary for these start-ups, or new entrepreneurs, to enter into a form of debt that will ultimately facilitate business growth.
Essentially, good debt is a type of debt that will result in an individual or business being in a stronger financial position than before taking on the debt.
It will usually arise through sensible borrowing and consistent repayments, resulting in improved credit scoring and a reliable credit history that will appeal to lenders. Certain types of personal and business loans can also be considered good debt.
Several types of debt can be considered good regarding personal finance.
The most commonly cited example of good debt is a home equity loan, or a mortgage debt. A mortgage is considered good debt because a home is often an asset that will have increased in value over time.
As a result, once the debt has been paid, you will be left with something of higher value than what it was before taking on the debt.
The need for a mortgage will most likely be unavoidable for first-time buyers. However, mortgage payment rates are usually manageable, and the net gains from this debt can be substantial.
Student loans can also be considered a good form of debt. This is because the loan facilitates a higher education that will put a person in a much stronger position regarding employability and earnings potential.
Student loan rates are often relatively low, and as long as the knowledge and experience gained through education lead to a well-paid job, the loan can be paid off without becoming a huge burden.
Sometimes, bank loans are a source of good debt, though this largely depends on what the loan is spent on. For example, if the loan is spent on home improvements or assets for a business venture, a person’s financial situation may improve in the long term.
Credit cards, such as Visa or American Express, are not often seen as sources for good debt. However, low-interest credit card debt can be used for credit repair, leading to a stronger credit score and more favourable arrangements with mortgage lenders.
If you are looking to rebuild credit through a credit card, check out our comparison tool, which will allow you to explore various options, many of which will come with a competitive low-interest rate.
Understanding the difference between good debt vs bad debt is vital for anyone who needs to make key financial decisions.
Debt becomes bad debt when the individual can no longer make monthly repayments or pay off debt. It also occurs when the primary reason for taking on the debt leaves a person or business in a financially weaker position. A car loan is often considered a source of bad debt. This is because a car's value quickly depreciates once purchased.
The most dangerous source of bad debt comes from high-interest payday loans. They are often used as a short-term emergency fund, and the fact that the cash usually appears in an account instantly makes them deceptively appealing.
However, if they are not paid off quickly, payments and interest will quickly escalate, leaving a person financially vulnerable and subject to bad credit scores.
If you or your business is struggling with bad debt, it is possible to rectify the situation and put yourself back into a position where the debt is at least improving your credit score.
One strategy for debt management is known as the debt snowball method. This is where you will attempt to quickly pay off your smallest debt and maintain minimum payments across your other debts. Once the smallest debt has been repaid, this commitment is continued and added to your next smallest debt until all debts are paid off.
You could also look to consolidate debt to reduce the overall interest paid on your commitments. Debt consolidation loans are an excellent means of debt relief as they are used to pay off all existing debt commitments simultaneously. This type of loan refinancing ensures you only have one repayment, rather than multiple monthly payments to concentrate on.
Check out a range of competitive loan consolidation options with our refinance calculator.
Avoiding bad debt is important for maintaining robust financial health. Fortunately, there are some simple things to bare in mind before you should consider taking on debt.
Firstly, you should be confident that you can comfortably afford the monthly payments.
Bad debt and interest can quickly accumulate if you fall behind on your commitments. If your circumstances change and repayment becomes more complex, you should explore alternative repayment options before things escalate.
You should also consider the reason for taking on a loan. Taking on the debt becomes more justifiable if it is used to make net financial gains, such as starting your own business. It might not be worth it if it is a personal loan used for more frivolous purchases, such as holidays and gadgets.
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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs, or financial situation.