What Is a “Good Debt”? 3 Things To Check.

What Is a “Good Debt”?

The following post is a guest post from Sara who blogs over at Debt Camel. She is a debt adviser and is full of knowledge about debt. She has provided many people with solutions and support to their debt problems – I recommend heading over to her site if you have problem debt, and are feeling lost. Over to Sara:

I’m a debt adviser, so perhaps you expect me to say debt isn’t a good idea, except for a mortgage or student loans…

But I live in the real world and so do the people I advise! In 21st century Britain people get loans and use their credit cards in all sorts of situations. So here are three things to ask yourself if you are thinking of borrowing money.

Can you afford it?

This is a good definition of affordability: “credit is affordable if you can make the repayments without cutting back and without borrowing any more money.”

If you are earning £2,000 a month and you are looking at a loan that will cost you £140 a month, it may not sound too bad. But how much of your income is already committed to your rent, council tax, utilities, regular bills, food, clothes, and everyday living expenses? If you are in your overdraft every month and only making the minimum payment to a credit card, can you really afford that extra £140?

If the answer is No, then don’t borrow the money. It doesn’t matter how much you think you need it. If you can’t afford it you will end up having to borrow again and this can become an expensive vicious circle. If you are already struggling with money, you need debt advice not more debt.

Will the debt last longer than what I will be buying?

Two examples illustrate this. A mortgage may last 25 or 30 years, but at the end of it you will own your house and can carry on living in it for free – that’s why an affordable mortgage is “good debt”.

Buy a pair of shoes on a credit card and only make minimum repayments and you will still be paying for them ten years after they have been thrown away. This is the minimum repayment trap that costs you a fortune. And it’s definitely “bad debt”.

But it’s not always that easy to apply the rule. Take cars – a large purchase people often need finance for. If you are buying a new or nearly new car, the amount it depreciates in the first few years is shocking, so your loan (plus interest) may not be buying you as much of an asset as you think. With PCP-style car finance, more than four in five people just change their car at the end for another one, on finance again. The interest rate itself may be pretty cheap, but the car industry has turned this into a way to make people keep paying for all that expensive depreciation, for car after car.

What about a holiday? My basic reaction is if you want to go on holiday every year, then you have to pay for this year’s holiday this year. Don’t kid yourself it’s a “holiday of a lifetime”, unless you intend not to go on holiday at all for a couple of years.

Is this the right time to borrow?

Borrowing now commits a chunk of your income until it is repaid. Think what you might want to do in the next few years that could be harder if you increase your debt now:

  1. get a mortgage;
  2. pay more into your pension;
  3. take a year’s maternity leave;
  4. retire early;
  5. start your own business.

Being able to borrow gives you options that you use up when you do borrow. Unless you have a good emergency fund put by, an authorised overdraft that you don’t use or unused credit on a card is your safety net if the washing machine dies and the car needs a service all in the same month.

I think this applies to student loans for a lot of people. If you know what you want to do at uni and it’s going to lead to a good career, then go for it and don’t worry too much about the student loans. But if your friends are all going to uni and you can’t think of anything else to do, that is a pretty bad reason. You may drop out if you don’t enjoy your course, or you may realise in a few years that you should have done a different degree. Taking a year or two and working first could help you think more about what you really want to do.

So should you take this debt?

If you can say Yes, I can afford it; Yes, I will have repaid the debt before the item has gone; and Yes, the debt isn’t going to cause problems in the next few years, then it’s not going to be “bad debt” for you. So you have one last check – make sure you get it as cheaply as possible!

good debt vs bad debt