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What is The Difference Between Good Debt and Bad Debt?

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What is The Difference Between Good Debt and Bad Debt?

You may be asking yourself what the difference between a good debt and a back debt is, surely all debt is bad. When you borrow money, you have to repay it with interest, and no one really likes to owe money. So, having said that what makes a debt good or bad.

The difference between a good debt and bad debt is the reason for the debt.

If you have borrowed money to make a frivolous purchase, such as paying for a night out on the town or unnecessary luxury holiday then you could consider this as being a bad debt.

If you have nothing to show for your money, no asset, no investment, nothing which you can trade then you may just have a bad debt on your hands for which you are now having to pay interest.

High Interest Rate Borrowing

Unsecured types of borrowing such as credit cards, over drafts and payday loans bring a higher risk to the lender and therefore they will come with a higher rate of interest for the borrower.

Credit cards: If you take a look at your average credit card you will see that they are offered with an interest rate of between 20% and 50% Average APR or annual percentage rate.

Overdraft: These are credit facilities extended to you by the bank which allows you to have access to funds immediately on your account. There are two types of overdrafts. Arranged and unarranged overdrafts. Unarranged or unauthorised overdrafts can be charged up to £8 per day. This can quickly add up over the month.

Payday loans: These types of short-term loans are considered to be high risk to the lender since payday loans are normally loans from small sums of money lent over a short time frame of between 30 days up to 12 months. Some payday loan lenders will charge up to 3,000% APR. The rate of interest of the payday loan is dependent on many factors such as the credit score, income, existing outstanding debts.

Borrowing at a lower rate of Interest

There are secured loans like as mortgages, personal loans and some car loans. Secured loans are guaranteed by the borrower against some sort of asset which they own. If the borrower fails to repay the loan the lender can repossess the asset to pay off the loan. Since the loan is secured against collateral it will come with a much lower interest rate.

Mortgages: Not many of us have the money to buy a property outright. We take out mortgages to cover the cost of the purchase of the property from the bank. The borrower is expected to have a deposit of at least 10%. The bank will require that the property the borrower is purchasing is put up as collateral. If the borrower fails to pay then the bank can repossess the property.

Personal Loans: Personal loans can be taken out at the bank for amounts up to £25,000. Banks would ideally prefer to have the borrower put up collateral against the loan. This is good for both the lender and the borrower.

For the lender there is less of a risk for not getting the money back. For the borrower the lender will offer a lower interest rate.

Car Loans: Just like getting a mortgage a car loan is normally a secured loan that is secured against the car being purchased. The larger the deposit you can provide the lower interest payments you will have to make.

What is a good debt?

In the simplest terms a good debt is when you borrow money to get something which will earn you money. Like buying a property to rent, or to take a course that will increase your market worth so that you may earn more. Maybe you are taking out a loan to either start a new business or buy a business. Either way you are taking out a loan to make it pay for itself.

What is worth borrowing for?

It is normal to borrow money to purchase property. In fact, it is better to borrow someone else money when buying property.

Let’s do a very quick example. Say a property is on sale for £200,000 and you have £200,000 in the bank ready to go. You purchase the property and 5 years later you sell the property for £250,000, you have made £50,000 profit (We are not taking taxes etc into account)

But what about if we took the £200,000 and bought 4 properties instead. With a deposit of £50,000 per property. Secure the loan against the property and the rental income to cover the mortgage.

Roll forward 5 years, now we have 4 properties each worth £250,000. Total profit of £200,000.

Ok, you may say that the rental income would have been more on the single property rather than the four properties.

If the rental on one was £1,000 per month, you would get to keep all of it. Over 5 years the rental income would be £1,000 x 60 months = £60,000

Now, onto the 4 properties. Say the mortgage was half the rental. £500 x 4 = £2,000 per month in rental income. £2,000 x 60 months = £120,000

Worst case scenario and each property is only making £250 per month after mortgage you are still bringing in the same as the single property, with the benefit of the large equity at the end of the 5 years.

Using your own money here is obviously not as good as using another persons money.

You could release the equity in the 4 properties and buy some more properties. Rinse and repeat.

The rich get rich because they buy assets first.

Examples of what some consider good debt:

Mortgage: Use other people’s money to buy property. Use as little of your own money as possible.

Student loans: Depends on the course. Some university courses are pointless and a waste of money and time, nothing which can’t be either learnt online. Then there are courses which will add huge amounts of value, such as engineering, medicine, law etc.

Stating a new business: This is one of the ways to grow your wealth very quickly. Taking out a loan to start a new business need not be as daunting as it might sound. Provided you focus on what you already know and understand. You understand your demographic and have a handle on your marketing you should be ready to roll.

Bad Debts

A bad debt is unsecured loan that you are having a hard time in repaying and is not used to finance anything which is making you money.

Credit cards: Credit cards are very handy if they come with 0% interest free periods to take advantage of balance transfers. Maybe you need a credit card for work expenses, I know I have needed one for securing a rental car, but I have never used a credit card to make frivolous purchase which I know I will have to repay at month end.

Borrowing for a holiday: Don’t, just don’t borrow money to go on holiday. If you can not afford a holiday, then don’t put yourself into debt for the sake of 2 weeks in the year.

Buying a new car: Do you really need a new car? What is wrong with your current car? If you really need to purchase new car to get to and from work, make sure you get a car with warranty that covers maintenance for the first year or so. Also, one that is less than 3 years old so you don’t have to worry about MOT.

Smaller engine cars will attract a lower road tax bill and lower fuel bill.

Payday loans or cash advance loans: This are short-term high interest loans which are taken out for a very short period between 30 days and 12 months. They are useful if you find yourself short of cash and used right, they can be really helpful. Ensure that you repay your loans on time and in full.

So, you see that there are good debts and bad debts. It all depends on what you intended to use the money for.

Focus on the good debts and lower your exposure to bad debts.

Debt management agencies are regulated by The Financial Conduct Authority

Many people in the U.K struggle with debts and many do not know how to start to repay them speaking to a debt advisor is one of the best things you will do along with taking action yourself by speaking directly with your creditors.

https://www.nationaldebtline.org/ and https://www.moneyadviceservice.org.uk

You should always seek professional advice when handling debt problems. Cashute are not licensed debt advisers and any information contained in this article should not be taken as legal advice. It is your Responsibility to seek out correct legal advice

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Warning: Late repayment can cause you serious money problems. For help, go to moneyadviceservice.org.uk