Your Money: ‘Good' and ‘bad' debts: Know the differences

Your Money: ‘Good’ and ‘bad’ debts: Know the differences
© Provided by The Financial Express These cards often have hefty interest rates and can rapidly become unmanageable.

By Supriya Suri

Loans play a major role in helping us realise our aspirations and achieve many life goals. Of late, consumers are increasingly using credit to make payments in a convenient manner, and do not wait to save and spend. But at the same time, certain debts tend to become a liability resulting in unwarranted stress. Thus, it is important to understand the difference between a good debt and a bad debt for anyone looking to make informed financial decisions.

What is ‘good debt’?

Good debt can be used to purchase assets that can depreciate slowly or, in some instances, grow with time. One can plan savings, loans and investments to maintain good financial health and ensure a settled and secure future. For instance, if one takes an education loan, it can be considered profitable as it is bound to give good returns and elevate earnings.

However, one should avoid huge debts as much as possible. A small sized consumer durable loan is always preferred for someone who is new to credit, as along with building a healthy credit score, such a consumer durable loan can help to increase affordability of items, thereby fulfilling aspirations.

Similarly, borrowing for affordable health insurance falls under good debt as these can safeguard from unexpected future risks. Also, borrowing to invest in a business is considered a good debt. No doubt there are risks involved, but with an assumption that one has accounted for the liabilities and assets well, this loan is considered a healthy choice. A good debt should be incurred with a calculated risk for a secured future/high return and to enhance one’s financial planning. Good debt gives leverage and further gains, whether it be through investment returns or education.

What is ‘bad debt’?

Bad debt is defined as a debt that has a negative impact on an individual’s financial wellbeing. A loan used to purchase a luxury automobile, for example, will be classified as bad debt if the EMI and total loan amount is disproportionately higher than the monthly income and annual income of the consumer. A high-interest rate loan is also termed bad debt since it imposes a significant interest burden on the borrower. Many people borrow to invest in places where they expect a better rate of return than the interest rate, which may or may not be the right decision.

Borrowing money to purchase services and products for one’s personal usage that do not offer any long-term growth are considered to be bad debt. One of the most common types of bad debt is owing money on a credit card. These cards often have hefty interest rates and can rapidly become unmanageable. Hence, avoid debt with high interest rates in order to achieve short term financial goals as the spending capacity and interest rates are vital when investing in these products and services.

Choosing the right debt

Debt is relative, situational, and specific. A good debt for one can be bad for another, depending on one’s financial situation. Good debt is essentially one of the best ways to gain financial freedom and reach long-term goals. Before applying for any loan, check whether that borrowing will bear fruitful results or will become a liability. It is important to carefully estimate your present financial health and evaluate how present borrowing will deliver long term benefit.

The writer is vice-president, Customer Experience, Home Credit India

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