Debt for a degree isn't the same as debt for fancy meals.
- Not all debts are created equally, and debt isn't automatically bad.
- Good debt funds assets or opportunities that can grow in value or generate income.
- Bad debt pays for lifestyle spending on things that don't hold value or build wealth.
Right off the bat, we're definitely not saying you should begin accruing debt for the sake of it. We all know debt isn't the greatest thing in the world - but a lot of the time it's necessary, and some types of debt can even help us create wealth.
The key lies in knowing the difference between good and bad debt - and there's a big difference between the two. One can benefit your financial future, while the other one can ruin it. The easiest way to tell the two apart is not by the amount of debt itself, but by what it's spent on.
Still confused? Allow us to break down the good debt vs. bad debt conundrum for you.
What is good debt?
There's an argument to be made that no debt is good debt. But there are cases where taking on debt will pay dividends in the future, which makes it 'good' debt.
In a nutshell, good debt is anything we borrow that's used to purchase something that will either grow in value or produce income (or even better, something that will do both).
Some examples of these 'good' debts are:
Home loans
Yes, mortgages are expensive and scary, and they can take a long time to pay off. But in the long run, a home loan is usually a good investment. Property values often rise over the long term, but growth isn't guaranteed and can vary significantly by location, property type, and timeframe. And if it's an investment property, it may produce income through rent.
Of course, if you overextend yourself by borrowing money for a home you can't really afford, that debt isn't good at all. Building equity in a home is good - being house poor is definitely bad debt.
See Also: Home Equity Calculator
Student loans
Student loans, such as HECS-HELP debt, enable you to get an education that can provide you with opportunities in your career and increase your earning potential. Generally, investing in your education can really pay off in the long run. Of course, this depends on various factors, including the career path you're pursuing.
Australian government-provided student loans are often considered to be some of the better debt you can have because there's no fixed repayment deadline, though they are indexed each year. Recent changes mean indexation is now capped to the lower of CPI or WPI, so your HELP debt can't grow faster than wages.
- Take note: While HECS-HELP don't charge 'interest' like a bank loan, the indexation can still increase what you owe.
Startup costs
Startup costs refer to anything that's borrowed to build something up, like a business. Even though you may be laying down a lot of cash initially, in the long run, you need to spend that money to start earning money.
Obviously, all investments carry an element of risk, and there's always the chance it may not pay off, but as long as you've considered all the risks, borrowing money to start a business may pay dividends in the long run.
What is bad debt?
Conversely, bad debt is debt used to fund your lifestyle, especially when it's spent on things that don't hold their value, don't generate income, and won't improve your financial position over time (or that typically go down in value).
While good debt can sometimes help you build wealth in the long run, bad debt tends to leave you paying interest and fees without much to show for it - which effectively can make it harder to get ahead financially.
Some examples of bad debts are:
Consumer debt
Debt incurred for lifestyle or consumer expenses you can't actually afford is perhaps the biggest form of bad debt.
For example, if you pay for clothes, dining out, entertainment, or furniture with your credit card and carry the balance over from month to month, you'll keep accumulating ludicrous amounts of interest and fall deeper into debt. Meanwhile, all those fancy clothes and nice dinners out aren't growing in value or increasing your wealth whatsoever.
Short-term loan schemes or BNPL like AfterPay and Zip Pay are another form of bad debt to watch out for. If you pay on time, costs can be low - but missed payments can trigger fees and other consequences.
Read more about every buy now, pay later provider in Australia here.
Payday loans are considered to be one of the worst types of loans across the board because they're short-term, high-cost loans. In Australia, these are often small amount credit contracts (generally up to $2,000). Costs are usually charged as fees rather than "interest", with many lenders charging an establishment fee of up to 20% of the amount borrowed, plus a monthly fee of up to 4%.
They're called payday loans as they are often set up to be repaid over a short period, sometimes aligned with pay cycles.
Car loans
Since most cars start to decrease in value pretty much as soon as you drive them out of the lot, taking out a car loan is a classic example of borrowing money for something that only goes down in value and costs you money along the way. This is why many people put car loans straight into the bad debt basket.
But the fact is, most people need a car to get around, and unless you can afford to pay for it upfront, you'll have to take out a car loan. Think of it as a life investment - having a suitable car for your lifestyle with the latest safety features can boost your wellbeing by giving you more freedom to get around, socialise, partake in activities, and have adventures.
- Quick tip: The key is to buy a car you can afford without going over budget and borrowing more than you can comfortably afford to repay. Sure, buying a Porsche Cayenne might make the drive to work something you even enjoy, but a second-hand Toyota Yaris will get you there just as well as a fancy-schmancy SUV.
Read Also: What are the different types of personal loans
How to avoid bad debt
As a general rule of thumb, if you can't afford to pay for something right now, don't buy it. It's generally better to wait until you've saved up enough money and avoid risking the negative financial impact of bad debt. Those new shoes can wait!
If you're unsure whether something falls into the good or bad debt basket, ask yourself if the thing the debt is being used to purchase will:
- Grow in value over time,
- Increase your wealth, or
- Significantly boost your wellbeing.
If it doesn't do any of these things, it's probably a bad debt.
If you want to grow your money while paying down debt, parking extra funds in a high-interest savings account can help you build a financial buffer. Compare your options below.
| Bank | Savings Account | Base Interest Rate | Max Interest Rate | Total Interest Earned | Introductory Term | Minimum Amount | Maximum Amount | Linked Account Required | Minimum Monthly Deposit | Minimum Opening Deposit | Account Keeping Fee | ATM Access | Joint Application | Tags | Features | Link | Compare | Promoted Product | Disclosure |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
0.05% p.a. Bonus rate of 5.30% Rate varies on savings amount. | 5.35% p.a. | $1,097 | – | $0 | $249,999 | $0 | $0 | $0 |
| Promoted | Disclosure | ||||||||
2.25% p.a. Bonus rate of 3.15% Rate varies on savings amount. | 6.00% p.a. Intro rate for 4 months then 5.40% p.a. | $1,134 | 4 months | $0 | $499,999 | $0 | $0 | $0 | Promoted | Disclosure | |||||||||
4.00% p.a. | 5.90% p.a. Intro rate for 4 months then 4.00% p.a. | $936 | 4 months | $0 | $249,999 | $0 | $1 | $0 | Disclosure |
Read Also: Pay off debt, save, or invest first? How to decide?
Savings.com.au's two cents
Even though some types of debt are better than others, if you have the choice between going into debt and not, you should always choose the latter - even if it means putting your purchase on hold while you save up.
One of the biggest financial challenges most people face is embracing delayed gratification by saving up for purchases when we live in a 'buy now, pay later' instant gratification-fueled time. It's never been easier to treat 'yoself and deal with the financial fallout later.
Ultimately, debt can be a tool used to help you access other opportunities - but it's never a guarantee. Always borrow money wisely and do your research.