Is there such a thing as good debt and bad debt?
UK households now have on average nearly £2,000 of credit card debt. In this article we explore how good debt vs bad debt and the grey areas in between.
In this article, we are going to discuss what debt is and the various different types of debt that are available to us. Although we tend to view debt as an inherently negative aspect of finance, the reality is that for most of us some debt is necessary: it’s unlikely that you will go to university without a student loan or buy a home without a mortgage.
What is debt?
But first, what is debt? Debt is money that you borrow from a company or person (the lender) and are required to pay back over a period of time. Typically, the lender will charge interest on the amount borrowed, which is how lenders make a profit. Interest is typically expressed as an annual percentage.
The amount of interest that a lender charges will depend on whether they think you are a “good” credit (that is, someone who is likely to pay back borrowed sums) or a “bad” credit (someone who is less likely to pay back borrowed sums). Often, the amount of interest that a lender charges will determine whether the type of debt that they offer is good or bad debt.
Good debt
Good debt is typically a large investment that you make in yourself that will pay dividends in the future (metaphorical dividends, not the kind you get from investing in stocks!). As mentioned above, this could include buying a home or a university education.
1) Mortgages
Mortgages are long-term loans that you take out in order to buy property. The bank uses the property as collateral against the loan, meaning that if you don’t meet the repayments on your mortgage then the bank can seize ownership of the property.
Mortgages are typically considered good debt for two reasons: capital growth and good interest rates. When you buy a home, you hope that in the future it will be worth more than its purchase price. This means that when you sell your home you will be able to repay all of your mortgage off in a lump sum (and hopefully have some left over to reinvest in your next home).
Additionally, mortgages typically charge low interest rates because in the event that a borrower defaults on their mortgage, the bank can take possession of the mortgaged home. This makes this type of lending less risky for the lender and so they are able to charge lower interest rates. Mortgages are also typically a very long-term commitment which further allows lenders to charge lower interest.
2) Student loans
A student loan is a loan designed to help students pay for their university education. Student loan terms vary significantly by country, so for this example we will refer specifically to UK student loans. In the UK, graduates are required to pay back their student loans in regular installments once their salary reaches a certain threshold and if you stop earning, you stop paying.
Students typically need to take out a loan in order to go to university. In most cases, people go to university in order to increase their career prospects and boost their earning potential. Therefore, the rationale for taking out a student loan is that a degree may generate financial benefits in the long run.
However, unlike mortgages, student loans tend to charge rather high interest rates because university is expensive and there is no guarantee that graduates will get high-paying jobs. This means that many students will not repay their full student loan and will have a chunk written off later in life; as such, interest rates are high to make up for the loans that will be written off.
Nevertheless, since student loans are required by most people in order to get qualifications required for higher-paying jobs, they can be considered a good form of debt. Additionally, unlike other types of debt, such as credit cards and bank loans, banks do not consider student loans when evaluating mortgage applications.
Bad debt and the grey areas
Bad debt is typically characterised by high interest rates. Payday loans and credit cards come to mind for most, but the crucial other factor to consider is what you are actually borrowing that money for. Generally, using debt to purchase things that you cannot afford and do not contribute to your future financial success is likely to be a big financial burden and risks the health of your credit score. If you are using debt to fund consumption and luxuries, then the chances are that this debt will be a burden.
1) Payday loans
Payday loans are very short term loans with incredibly high interest rates. Payday lenders tend to aggressively advertise their products to lure people in with the promise of not checking your credit history, which is something that most lenders will do before extending a loan to a borrower. Payday lenders expect to make an enormous amount of money from people failing to make repayments on time and racking up huge amounts of interest; these interest payments often exceed the value of the loan itself.
2) Credit cards
Credit cards are a prime example of debt that can be either good or bad. Credit card providers charge high interest rates on late or missed repayments, which can quickly become unmanageable. However, they can also be used well and many credit card companies offer reward points, periods of interest-free borrowing and sometimes cash-back for spending with them. If you are highly disciplined, spend only what you can afford and repay your full credit card balance each month, then credit cards can be very useful. The risk, however, is that overspending or missing repayments can sting you with a very high rate of interest.
3) Buy Now, Pay Later
BNPL is another grey area when it comes to determining if it’s good or bad debt. BNPL providers enable consumers to spread out the cost of purchasing expensive items over several months. This can be extremely useful if you need to buy a costly item, such as a sofa or a fridge, but don’t want to take a huge financial hit all at once. In these cases, BNPL can be a useful way to manage one’s cashflow - particularly since BNPL providers do not charge interest to consumers (instead they take a fee from retailers). However, a lot of consumers forget that BNPL is effectively a form of debt and fail to keep track of just how much they have spent, which can easily lead to overspending.
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Common wisdom dictates that debt should be avoided. However, in today’s society, debt is a necessary part of life if you want to go to university or purchase a home. Nevertheless, not all debt is equal: some types of debt, such as payday loans, carry extremely high interest rates and can be universally considered bad debt. Lastly, there are some types of debt, such as credit cards and BNPL, that can be beneficial but should be used with care because they have the potential to, respectively, leave a borrower with hefty interest charges or encourage overspending.