Good Debt vs. Bad Debt : Debt are the taboo for investors for a long time, although attitudes are changing fast. Today, there is a more structured thought process about debt that categorizes it into good and bad debt. The latter are apparently responsible for people getting into debt stress and debt traps. This is because bad debt usually comes at a high cost and does not create anything productive, either tangible or intangible. Bad debt is the expensive debt that you use to finance your lifestyle expenses.
Good Debt vs. Bad Debt
There is a fine line between good debt and bad debt (Good debt vs. bad debt). However, there are some simple rules that can be applied. For example, any debt that helps to create tangible assets for the future or acquire intangible skills for the future, or that helps to reduce your debt burden, is good debt. Debt that increases your debt-to-income ratio, leads to high costs, or is used to purchase comforts and conspicuous consumption needs, on the other hand, is considered bad debt.
Looking at it the other way around, good debt adds to your positive value in the medium to long term. For example, a mortgage loan to purchase a property can improve your net financial worth because it lowers your rental costs and also creates a sizable asset like a home on your personal balance sheet. These benefits can legitimately increase your net worth in the long run. Another example is taking out a loan against your gold holdings and using the low-cost funds to repay your expensive debts. The gold is still yours as long as you pay the interest on time, and it is a valuable asset. On the other hand, paying off your expensive loan increases your net worth by reducing your debt-to-income ratio. The two questions you need to ask yourself to recognize good debt are: Does the debt help create assets that increase net worth, and does the debt help me reduce my debt service-to-income ratio. If the answer to both questions is ‘yes’, it is good debt.
Some examples of good debt?
At the risk of sounding trite, we must emphasize that good debt must meet at least one of two conditions. It must either contribute to the creation of assets that increase your net worth in the medium to long term, or reduce your debt service to income ratio. Here are some examples. Home mortgage loans are an example of good debt. There are several benefits. In India, real estate is an appreciating asset in the medium to long term. Also, the cost of finance is quite low, and it goes down further if we consider the tax benefits of a home loan under Section 24 of the Income Tax Act.
Another example of good debt is a business loan that you take out to expand your growing business. Here, you are betting that the business will eventually grow and generate more revenue. Also, the interest on the debt can be tax shielded, making it all the more productive.
How about an education credit to create intangible assets, such as a higher degree in artificial intelligence (AI) or machine learning (ML). It’s clear that AI and ML will change the face of business. This means they will give your career and earning potential a long-term boost. Plus, education loans are cost-effective and tax-deductible under Section 80E.
Finally, there are loans that increase the value of your business by lowering the cost-to-income ratio. If you are stuck with expensive debts, use your assets as leverage. Use your gold, real estate or stocks to take out a secured loan at a low cost and reduce your expensive debt. This way you can reduce your debt service in relation to your income. This is the heart of the matter. Good debt either creates a valuable asset, builds a valuable skill or lowers the debt service to income ratio for you. Is everything else bad debt?
Taking on debt you can not afford is bad debt. Similarly, taking on debt to buy consumer goods you do not really need is bad debt. If your lifestyle and debt management (Good Debt vs. Bad Debt) are driving you deeper and deeper into debt, that’s also bad debt. This is what bad debt looks like. Taking out a loan to buy a used car to save time and travel expenses is acceptable debt. However, the difference between good debt and bad debt is the degree of prudence. This is bad debt. Surely you need to spend on consumer goods. It’s not just about peer pressure, it’s also about what the family needs. But taking out an expensive consumer loan to buy an 80-inch UHD TV to watch the IPL is simply nonsensical.
And finally, using your credit card like a debit card is also bad debt, especially when you consider that it costs over 40% per annum and you are letting the debt roll on by paying only 5%. The distinction between good and bad debt is about the degree of prudence. Debt is not an abomination; it’s when you become careless with debt that the problem of bad debt begins.
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