Good Debt vs Bad Debt: What Do You Owe?

|Posted by | Debt Management

good debt vs bad debt whats the difference

Not all debts are bad. In fact, some debts can be good for your financial future. Read on to find out what type of debt you owe.

First published on 8 January 2016. Last updated on 24 November 2016.

To most Singaporeans, all debt is bad. It’s money you owe, and that’s never something we look forward to.

In reality, things get more complicated. There is, after all, a reason why even rich people take loans for their houses even when they can pay everything in full. It’s because not all debts are equal – some are good debts, and some are bad debts.

what is good debt

What is Good Debt?

A debt is often defined as good when it is an effective use of leverage. Without overcomplicating things, consider this example:

Say you borrow S$2 million to buy a house, which is valued at S$2.4 million (you cannot borrow 100% of the value). With a 30-year loan tenure, at an interest rate of around 1.7 to 1.9%, monthly repayments will be around $7,500 a month.

To most people, this is a frightening burden to take on.

To a savvy property investor, this might be a gold mine. A competent landlord might take such a loan because she realises that the well-located house can generate at least S$9,000 in rental income every month.

In effect, the landlord would be making S$1,500 each month from the house, even after covering the loan repayments.

After 30 years, the landlord sells the house for S$3.5 million, because its value has appreciated. The difference between the buying and selling price yields a profit of around S$1.1 million. On top of that, 30 years of rental income (assuming no vacancies) would have yielded S$540,000.

Where less savvy people saw a S$2 million debt, the landlord saw S$1.6 million for the taking.

This is the thinking behind “good debt”. It is a form of debt which more than pays for itself.

Examples of Good Debt

Generally, a good debt is an investment with returns that exceed the debt and its repayments. In the above example, the investment is property. In other cases, the investment may be assets such as stocks and bonds, or gold.

Here are some other examples of good debt.

Education Loans

While a degree may be expensive, it can provide career opportunities that will repay the education loan many times over. For example, many people accept the exorbitant costs of a law degree, because a lawyer’s income over just three to five years is more than enough to repay it.

Business Loans and Investment Loans

Businesses often need capital to start up, or to expand. The business borrows the money because, once it turns a profit, it will generate more money than its loans cost.

Using the same logic, individuals can also take personal loans for investments, and it will be considered a good debt when the investment generates more returns than the cost of the loan.

Note, however, that none of the above outcomes are guaranteed. A business that takes a loan, and then fails to turn a profit, would have raised its burdens. An education loan sometimes doesn’t pay off (e.g. there happens to be an oversupply of graduates in the workforce).

And as for investments, there is never a reliable way to tell if they will pan out as expected. Houses do fall in value, as do stocks, bonds, and commodities like gold.

In general however, if the investments work as expected, the debt incurred to acquire them is considered good debt.

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What is Bad Debt?

Bad debt offers no possibility of raising your net worth. The money used to repay bad debts is simply lost.

An example of this is incurring credit card debt to buy a new game console. As an electronic device, there is no chance you will be able to resell it at a profit (unless, 50 to 100 years from now, it somehow acquires antique status.) Nor will the console directly generate income. In fact, it will just cost you more money because you also buy games for it.

Note that some bad debts may be unavoidable in life. You may need to take a loan for medical reasons, or if you face litigation. The key is to ensure that you incur bad debts only under these necessary circumstances.

Avoid incurring bad debt for luxuries, such as taking big loans to go on vacation, or buying the most expensive car you can take a loan for.

If you have no choice but to acquire bad debt, avoid using a cash advance from credit cards. The interest rate is too high at 24% per annum, and you often have to pay a cash advance fee.

Instead, find a personal loan with a lower interest rate (about 6% per annum) and a manageable instalment plan. This will encourage you to pay back the loan on time so your debt doesn’t snowball.

Read This Next:

5 Warning Signs Your Debt is Out of Control
What Really Happens When You Can’t Pay Your Credit Card?


Ryan
By Ryan Ong
Ryan has been writing about finance for the last 10 years. He also has his fingers in a lot of other pies, having written for publications such as Men’s Health, Her World, Esquire, and Yahoo! Finance.