Good Debt Vs. Bad Debt: Know How To Leverage Debt
Key Takeaways:
One may believe that debt is something that one should avoid at all costs and if it is necessary to take a loan, it is essential to repay it as quickly as possible. However, debt is not always inherently negative – there are good and bad debts.
The key to borrowing effectively and using the available funds for wealth building is understanding the difference between good debt vs bad debt.
What Is Good Debt?
Good debt is a loan or any other form of credit that contributes to your financial growth and creates long-term value. Since it often extends returns that outweigh the borrowing costs, this type of credit is generally termed an investment of sorts.
These types of credit facilities generally come with affordable interest rates that don’t strain your finances. The following are some examples of good debt:
Taking a loan to acquire the house of your dreams is an example of good debt. It can be an excellent source of income, since it may provide rental income or its inherent value appreciates over time.
Taking a loan for higher education or professional development courses can allow you to get better job opportunities. This will lead to an increase in your income.
Taking credit to finance a business or its expansion can help you generate profits. Therefore, a well-planned business loan can ensure sustainable growth.
Identifying Bad Debt
Bad debt is when you take credit for non-essential purposes, like investing in a depreciating asset or in something that adds little or no value. This can lead to financial strain due to high interest rates and the lack of any long-term benefits.
The following are some examples of bad debt:
Using the entire credit limit of your credit card and making only the minimum payments results in increased interest charges. This can lead to further debt accumulation, making it difficult to manage your finances.
Using one loan to repay another loan with higher interest rates often leads to a cycle of debt. This can also lead to financial strain over time.
Luxury cars start depreciating in value as soon as you drive them out of the showroom and don’t generally contribute to income.
This refers to a short-term credit facility offered at very high interest rates. Due to impractical borrowing terms, it is easy for a borrower to get trapped in a debt cycle.
Leveraging Debt to Build Wealth
Depending on your risk tolerance and financial goals, here is how you can leverage debt effectively for wealth creation:
Get a home loan to purchase a property, allowing you to earn through steady rental income or value appreciation.
Using a loan to start a business can empower you to build a profitable venture with sustainable, long-term revenue growth.
Borrowing money as a student loan is considered a good debt. By upskilling yourself with a degree or another professional course, you can earn more in the future.
Tips for Smart Borrowing
Borrowing to grow wealth is all about minimising risk and maximising benefits. Here are some key tips to keep in mind to make smart borrowing decisions:
Assess Your Cash Flow
When building wealth using debt, you need a healthy cash flow. Lenders generally check your income before approving your credit request.
Check Interest Rates and Repayment Terms
Compare interest rates, fees, and terms from multiple lenders to ensure that you can get credit most affordably. Even a small difference in interest rates can make a big difference in your borrowing cost over time.
Consider Your Loan-term Goals
Create a list of your long-term goals and estimate the amount needed to achieve them, including your retirement savings and income requirements. Your goals will guide you in selecting the best investments for your needs.
Develop Your Investment Strategy
Your risk assessment, credit score, long-term goals, and cash flow are the foundation of your investment strategy. Use these factors to choose debt investments that align with your needs.
Frequently Asked Questions
1. What qualifies as good debt?
Credit taken for a financial gain or addition of value that outweighs the cost of borrowing is termed a good loan. For instance, student loans, home loans, and business loans are considered good debt.
2. How does bad debt impact my credit score?
Bad debt may lead to missed payments or a high credit utilisation ratio. This indicates a higher risk of default and can negatively impact your credit score.
3. Can student loans be considered good debt?
Yes, since student loans taken for higher education or a professional course increase your skillset, you may land a better job opportunity. This leads to long-term financial gain through increased income.
4. How can I leverage mortgages to build wealth?
Consider that you want to buy a property valued at ₹10 lakh with a down payment of 40%, which would be ₹4 lakh. Say the property appreciates at a rate of 5% per year. After just a year, your net worth would rise to ₹10,50,000. However, if you had purchased the property outright without any loan, your net worth would only increase by ₹50,000 over the same period.
5. Should I pay off bad debt before investing?
It is best to pay off the debt with the highest interest rates first before you start investing. Paying off debt helps you maintain and increase your creditworthiness so you can borrow credit in the future more affordably. It also reduces any penal interest you may have to pay if your dues remain unpaid.