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Looking to take out a loan? Before you do, you should know the difference between good and bad debt

Borrowing money means that you can have access to funds or capital now, with the trade-off of needing to repay that debt with interest into the future. File Image: IOL

Borrowing money means that you can have access to funds or capital now, with the trade-off of needing to repay that debt with interest into the future. File Image: IOL

Published Apr 19, 2022

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Borrowing money means that you can have access to funds or capital now, with the trade-off of needing to repay that debt with interest into the future. Such debt, however, can have positive or negative consequences – and the intended use and repayment structure can influence whether we refer to these as ‘good’ or ‘bad’ debt.

“A simple rule about debt is that if it increases your net worth or has future value in helping you progress financially, it is considered to be good debt,” says James Williams, Head of Marketing for short-term lender Wonga.

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“If it doesn’t do that, and the borrower isn’t able to make their promised repayments, it is bad debt.”

What is the difference?

GOOD DEBT

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‘Good’ debt allows an individual to manage their finances more effectively, to buy things they need or to handle unforeseen emergencies, or to acquire larger and more capital-intensive assets, such as property.

Examples of good debt are taking out a bond for a home, buying things on credit that save time and money, or investing in oneself by borrowing to further an education.

“Repaying these debts timeously is a meaningful way to improve your credit score – and making overpayments on debt, where possible, can help you close your active accounts more quickly, which can result in less interest charged on a loan. This is a great way to put ‘good’ debt to use to further your investments (such as in your home) or otherwise help you progress in your financial journey,” adds Williams.

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BAD DEBT

A bad debt is a sum of money that has little or no prospect of being repaid timeously or puts too much financial stress on the borrower who is unable to repay it as they originally agreed.

Identifying bad debt isn’t difficult. If it loses value the moment it is taken ownership of, it is bad debt – a good example could be splurging on designer clothes on retail credit or purchasing non-essential items on a credit card. While buying a vehicle through finance can have great utility, it’s worthwhile to consider that the vehicle will depreciate as an asset, while your monthly repayments may only increase as interest rates change.

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“Taking on debt should not damage your overall financial position,” explains Williams. “Borrowers should ensure that their repayments shouldn’t eat into money they need for living expenses such as rent, bills and other essentials and shouldn’t get in the way of important financial goals, such as saving for a house deposit or contributing to a pension.”

Williams advises that borrowers should be sure that they can meet the repayments for as long as they have the debt. “It is usually best to pay off debt as quickly as possible, to minimise its cost and impact,” he adds.

“The number one rule for taking on debt is simple,” he concludes. “Think carefully before taking out credit for something that is not a need or will not be beneficial in the long term.”

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