What is the difference between good and bad debt?

For the majority of us we will acquire at some point in our lives debt. Now debt does have negative connotations associated with it, however, debt is not all bad.

The whole point of my blog is to keep the language simple and concepts digestible (unlike some out there!) so to some readers it might appear as if I am teaching you to suck eggs, however, I want to cover the basics first and then work up from there so bear with me!

Now, let’s talk about debt.

We have all heard of the term ‘debt’ and we are taught in school that debt is bad, bad, bad but no one tells you that good debt also exists. 

What is the difference between good and bad debt?

First of all, in order to understand the different types of debt that coexist, we need to understand the difference between an asset and a liability.

In August 2020 I did a very basic bookkeeping course (nerd!) to try and gain an insight into accounting and how to handle my finances, which is where I learned that: (to put it simply)

An asset = is something you own that puts money into your pocket.

A liability = is something that will take money out of your pocket.

For example, if you buy a rental property that is an asset because it will pay you rental income each month; whereas, a car is a liability because it will take from you each month (MOT, petrol, repairs etc) and will NOT pay you back.

How does this relate to debt you ask? Well, good debt is a loan that can leave you better off financially in the future because it usually allows you to acquire something of value (e.g. a house) and is set up with a structured, affordable debt management plan (e.g. a mortgage). 

Another common example is student loan debt. While the government temporarily covers your (extortionate) annual tuition fees at university, studying to get a qualification is a positive investment for your future. It is good debt because the student loan comes out of your pay cheque from your employer each month in a structured manner. 

(Having said this, it was questionable at the time when the Government increased the annual university fees in the UK from £3000 to £9000 per year!!! I started university a year after this was introduced and, by Jove, did that hurt!)

Usually the rule of thumb is good debt is associated with assets and a liability is associated with bad debt, however, that is not always the case:

If you wanted a heated discussion at the supper table, drop into the conversation whether people think your home is an asset or a liability and you’ll be surprised how divisive the topic is. Your home is an emotive subject so in a non-financial sense it is an asset in so far as it gives security, stability and a place to be proud of; however, your house does not pay you monthly/annually and in financial terms is a liability because each month you have to take money of your pocket to pay for it (mortgage, bills, repairs etc). Thought-provoking though, isn’t it? 

In contrast, bad debt is normally considered as being an unsustainable method of financing something because of the high interest rates it incurs. The loan can then become unaffordable to the point where you might not be able to pay back the money you borrowed, which the bank wil write off as irrecoverable. 

For instance, if you rack up quite a lot of credit card debt and fail to pay back the minimum monthly amount, your bank account will go into ‘arrears’ (i.e. money that should have been paid earlier and is now owed). The lender – the Bank – will then get in touch and charge you daily interest on the original amount that you owe them so over a short period of time you can see how that sum of money can increase exponentially.

According to investopedia, the definition of a debt collector is: “Debt collectors use letters and phone calls to contact delinquent borrowers and try to convince them to repay what they owe”.

To mitigate the risk against losing money as uncollectible debt, the bank might secure the loan against something. What that means is, if you want to borrow money to buy a new, flashy car the bank will give you a loan that is secured against your car. Therefore, if suddenly a few months down the line you can no longer afford the monthly payments and your account goes into arrears – the bank will take your car from you, sell it and keep that money to get back the money borrowed. The same thing can happen with your house – the bank will secure your mortgage against the property.

So on that cheery note, hopefully you can understand the point I am trying to convey here: if you can try to only take on good debt, and avoid bad debt.

In my next blog I am going to cover how to better your chances at getting a loan (if this blog post has not put you off getting one!) by telling you about Credit score UK.

To finish then…

I like to add a fun twist to the end of my blogs and include a health tip to encourage everyone to stay healthy. I am a doctor after all. Go to the about me page to find out more about my story.

Today’s health tip is: sleep quality is closely linked with weight. Studies have shown that those who sleep for 7-9 hours have a lower BMI than those people who sleep for an average of 4-5 hours a night.

Please remember that this is not financial advice and I am not a financial advisor. For more information please go to the disclaimers page.