All the latest news, facts and tips from the team at Pioneer Credit Connect

Dec 17

Good Debt, Bad Debt

by Lachlan Hayes
Good Debt,Bad Debt.

If you haven’t borrowed money before, it's likely you at least know someone who has. In fact, between 2015 and 2016 the Australian Bureau of Statistics determined that almost 75% of households have debt.

Debt can be useful. It helps people buy houses, pay for university, or provide a safety net of extra money when you’re on holiday. Despite this, taking on debt can be risky. It is important to assess the need for borrowing to avoid taking on unnecessary debt.

A starting point for deciding to borrow is determining whether you are taking on good or bad debt. You can determine whether a debt is good or bad based on if it is going to add or detract value from you over time.

Think of it like this; if you borrow money to purchase an asset that will make you money in the long run, it is good debt. The contrary applies to bad debt, which is purchasing something that will lose you money in the long run.

Borrowing often comes with an interest rate that must be paid on the loan, which is sometimes referred to as the cost of borrowing. For a debt to be a good debt, the asset purchased will make income, or add value at a higher rate than the interest on the loan.

One example of a good debt is a mortgage. Mortgages typically have lower interest rates than most loans. This makes it easier for the return on your house to be larger than the interest rate. Buying a house does not guarantee you will make money, but it is possible with careful decision making.

Another example of a good debt is a business loan. You may have heard the saying “you have to spend money to make money.” This, of course, is not always the case, but a business loan can give you some help in kick-starting your own business.

Bad debt is the most common type of debt and can be nearly impossible to avoid. It is best to steer clear of it is possible. Bad debt typically comes with a higher interest rate and can include products such as credit cards, personal loans, and cars. Car loans are a great example of bad debt. Car financing is often used to purchase new cars, which lose a significant amount of value the moment they roll out of the dealership.

This is unavoidable whether you buy the car with borrowed money or your own money. However, using borrowed money to purchase a new car can set you back even further. This is because you still need to pay interest on the financing. If you must pay interest and the car loses value, the car will not only struggle to make money faster than the interest rate, it won't make money at all.

Credit cards are another form of bad debt, and generally, have the highest interest rates of any debt product. Credit cards are often used to purchase clothes, jewellery, and even food. Whilst some of these things are necessities, it’s best to purchase them with money that isn’t borrowed.

Good debt can help you purchase assets that will help secure a more financially stable future, while bad debt can set you back. It is important to be able to tell which is which and only take on bad debt if it is completely necessary. If you are considering borrowing money, you should consider if it is going to become a good or bad debt, and whether it could be worthwhile saving up instead.

Now, if you have read this and are thinking “I already have bad debt, what do I do now?” then keep reading. Most Credit Cards and Personal Loans are all designed to keep you in debt; just like how cigarettes have nicotine in them to keep you coming back. The more of these accounts you have, the more you will have to pay in fees and interest seeing as the bank is trying to penalise you for having bad debt; subsequently making it harder and harder to pay them off. Just like with cigarettes, the more you have, the harder it is to quit.

But how do you get out of this cycle? A debt consolidation loan can act as Nicorette gum, it's not a perfect fix, but it’s a step in the right direction to break the bad debt habit. Essentially, debt consolidation is where you take out a personal loan and use it to pay off all of your existing accounts. You now have the peace of mind of only paying off one account as well as being able to potentially secure a lower rate.

The next steps:

You consolidate all your bad debt into one account; preferably one with no fees, a low rate and no redraw. You then cut up your old credit cards, close down your old accounts and pay that debt consolidation loan off like its going out of fashion. Now, this is the trick that will take you from being okay with money, to a money master. Once you have paid the consolidation loan off, you will be so used to living on the remainder of your regular pay that you can keep that payment going, but now into a savings account.

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