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Good Debt vs Bad Debt: Considerations for Borrowing

Although it’s true that too much of the wrong sort of debt can be extremely bad for your finances, the reality is that there is such a thing as “good debt”. For all sorts of reasons, many people are reluctant to get into debt of any type, fearful of squandering their money on a lifetime of repayments and interest. 

That said, the right sort of borrowing (good debt) can see you end up with an asset that appreciates over time to more than compensate for any interest you paid on the loan.

Here we take a look at both good debt and bad debt. We describe what each sort of debt is, as well as consider the impact it can have on factors such as your ability to borrow, interest rates on future loans, and the likelihood of enjoying a good return on your initial borrowing.

Read on to discover the outcome of the good debt vs. bad debt debate, and when lending could be the perfect way to secure your financial security in the future.

[Related: Seven Questions to Ask Yourself Before Refinancing]

What is Good Debt? 

Good debt is defined as borrowing that has, “the potential to increase your net worth or enhance your life in an important way”. Whilst businesses may borrow to invest in a wide range of ventures, most private individuals will tend to borrow to invest in property or land

The Advantages of Good Debt

Borrowing to Save Cash in the Long-term

Obviously, if you borrow to purchase a property, you’ll no longer need to pay rent. Whilst you’ll still have to service your mortgage, the money you’re paying back isn’t “dead” money, it’s being put towards your own property investment.

Most financial experts agree that in the long-term, homeowners are almost always better off by borrowing a mortgage than they are by continuing to rent. Rising home values mean that the value of a property often rises far above the cost of servicing a mortgage to own it. 

[Related: Tips on Budgeting for How Much Home You Can Afford]

Acquiring an Asset

An asset is an object, property, or piece of land that has the potential to net you an attractive resale value. If necessity arises, it’s an item that can be converted wholly or partially into cash. This may be for a planned life event (retiring or paying college fees, for example) or to cover emergency expenses. When it comes to a property, once you’ve lived in it for a few decades, you may wish to rent it out or release some of the equity in it for other purposes.

Your property is also likely to form the bulk of your inheritance, providing something of value to pass down the family line.

Enjoy Welcome Tax Breaks

When you borrow to buy property, you may also qualify for a number of attractive tax breaks – ask your accountant or mortgage planners for further details.

Increasing Your Future Borrowing Potential

Two factors that have a significant effect on the ability to borrow are your previous track record for repaying debt and the amount of security you have to offer should you wish to take out a secured loan or act as a guarantor for someone else’s borrowing (many parents act as a guarantor for an adult child’s mortgage, for example).

Taking out a mortgage (and keeping up with the installments) can increase your credit score, ensuring you appear a more favorable prospect to lenders in the future. The better your credit score, the more likely it is that you can obtain future borrowing (or a remortgage) at an attractively low rate of interest.

In summary, “good” debt is usually an essential part of shrewd financial management and an important necessity for the creation of wealth.

[Related: Eight Compensating Factors for Mortgage Approval]

What is Bad Debt?

Bad debt may be defined as, “borrowing money to purchase rapidly depreciating assets or only for the purpose of consumption”.

At its most basic, bad debt is debt that doesn’t leave you with anything tangible as a result of the borrowing. Examples of bad debt may include borrowing to pay for holidays, new clothes, fresh household appliances, or to finance items you would like, rather than items that you need.

Bad Debt may Still Improve Your Credit Rating

Paradoxically, some bad debt may increase your ability to take out good debt. Your credit record is, to a large extent, determined by your history in debt repayment. If you don’t have a history of debt repayment, you may not be able to obtain such a large loan as someone with a history of borrowing. Whilst this isn’t a reason to spend beyond your means, it may be the case that a small amount of lending (that you repay on time) to finance non-essentials may leave you in a stronger position to “borrow big” on your mortgage.

[Related: Expenses to Know About Before Buying a Home (Beyond the Down Payment)]

Bad Debt Isn’t Always Bad

Whilst spending on non-tangible expenses won’t ultimately contribute to long-term wealth, there are some circumstances where it may be justified for personal reasons (travel costs to visit a sick relative, for example, or a modest vacation to “make memories”). 

Bad Debt Danger Signs

Whilst taking on bad debt may not be the wisest of financial decisions, there are some situations where it can be extremely damaging. If you are aware that any of your existing debt is for the following reasons, it’s important to get expert financial advice promptly.

  • Borrowing to pay household bills or other essential outgoings.
  • Borrowing to pay off the installments of an existing loan, credit card, or mortgage.
  • Increasing levels of bad debt (for example on store or credit cards) with on commensurate rise in income to repay the debt.
  • Borrowing to finance gambling or other addictive behavior.

Remember that if you fall behind on making repayments on loans, store cards, or similar, you risk a poor credit rating (as well as financial penalties) that could prevent you from being successful in obtaining the mortgage you want in the future.

[Related: How to Avoid Being House Poor]

The team at Seattle Mortgage Planners can help with every aspect of your mortgage selection and application process. No matter what your financial circumstances may be, we will always try to find a solution that’s right for you. 

Get in touch to find out more about your options and how we can help.

Featured image via Unsplash

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