A conservative viewpoint is always to take on as little debt as possible. However, not all debt is bad and we don’t need to go all out to quickly pay off all debt. Recently, many financial gurus have been advocating taking on good debt and reducing bad ones. So what’s the difference between good and bad debt?
Good Debt versus Bad Debt
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A simple explanation is that good debt will be able to increase your wealth, while a bad one reduces your wealth. The easiest example of a good debt which most people will take on is a housing loan. By taking on a loan to buy a house, you are able to use only say 20% of the total amount to purchase the house. However, when the house appreciates over time, the appreciation will be on the entire amount hence the returns are magnified.
Bad debt is generally using it to purchase a lifestyle item or service, for example using installment payments to buy a brand new tv. Using debt for such a purchase usually means that you do not have enough to pay for the full payment up front.
The Problem With Bad Debts
If you buy something on an installment plan, it probably means you cannot afford it. By splitting the bill over several months or even years gives people the false illusion of affordability. Another problem is that while the installment amounts may be small each month, they quickly accumulate over time to the point where even on a monthly basis, you may have trouble servicing the installment payments.
Too Much of A Good Debt?
Too much debt is certainly not a good thing, be it good or bad. A good debt can become bad suddenly. For example, a mortgage loan used to invest in a property which later crashed in value by 40%. Good debt was utilized for an investment, but it turned bad because now the house has a lower value than the housing loan you owe to the bank. This becomes problematic when you overstretch yourself and cannot cover the loan payments if there are no tenants.
The crucial point before incurring a debt is to completely understand what the cash from the debt is used for and the effect it has on you financially in the long-term. If it is used to purchase an asset, make sure that the utility or financial return from the asset is higher than the cost of the debt. It is also vital to ensure that you are not overleveraged where your borrowings exceed your assets or where you have difficulty servicing the loans. It is not advisable to take on any new debt when you are overleveraged, regardless of its purpose.
Of course for bad debts, it is best to avoid it in the first place. For any lifestyle purchases, it is best to pay everything upfront and avoid using installment payment plans no matter how attractive they sound.
About the Author
Calvin Yeo is the Managing Director of Doctor Wealth Pte Ltd (www.drwealth.com), which is an online financial planning platform. He is also a Chartered Financial Analyst (CFA) as well as Certified Financial Planner (CFP).
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