Bad debt or good debt: what’s the difference?

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Do you think that debt is a bad thing? It might surprise you to know that there’s such a thing as good debt. When it comes to personal finance, borrowing money is divided up into two categories: good debt and bad debt.

And, while there are a few things that are a bit of a grey area, there’s a quick rule for deciding whether the money you’re thinking of borrowing is good debt or bad debt.

Good debt is – usually – money that you borrow to pay for items that are going to improve your financial situation in the long run, or to buy things that are essential.

Bad debt, on the other hand, is money that is borrowed to pay for non-essential items, things that you want or things that are going depreciate in value or leave you financially worse-off in the long run.

What counts as good debt?

Student loans
Student loans require you to borrow a lot of money, but it pays off in the long run. University graduates, on the whole, earn more than people without a degree. Plus, the way that these loans work (almost like tax and National Insurance) means that you don’t actively pay off the debt – the money is taken from your salary, pre-tax, and you only have to pay when you earn over the threshold amount of £21,000 a year. (After that, you start to pay 9% of every £1,000 over £15,000 you earn. Plus, if you haven’t paid it off after 30 years, the debt is wiped off of your record.)

Taking out a mortgage
Again, mortgages normally mean that you’re borrowing a lot of money – but once you’ve paid it off, you own a house which, unless the housing market has taken a downward turn, is worth more than you paid for it. Plus, if you can get a mortgage, monthly payments are often cheaper than rent.

Investing in your own business
Blood, sweat, tears, stress, frustration, hard work – all of these things are essential to starting your own business. But, sometimes, you need an injection of money too. Whether it is to buy the equipment to get started or to rent a property, sometimes the only way – as the old saying goes – to make money is to spend it. Borrowing money to fund working as your own boss is seen as good debt, because you’ll be borrowing in the short term to earn money in the long term.

OK, I’ve got that, so what’s bad debt?

Well, pretty much anything else. Credit card debt, pay day loans, loans to pay for holidays – the list goes on, but they’re all, at their most fundamental, non-essential amounts of money that are not going to accumulate over time. That’s bad debt.

The Money Advice Service defines bad debt as: ‘[Debts] that drain your wealth, are not affordable and offer no real prospect of ‘paying for themselves’ in the future. Bad debts are also likely to have no realistic repayment plans, and are often run up when people make impulse purchases of items they don’t really need, or borrow money to pay every day bills. If you can’t afford to borrow the money (for example, you aren’t sure you’ll be able to make the monthly repayments) it is definitely a bad debt.’

What about debt consolidation loans? Are they good or bad debt?

This is an interesting question – and one that we don’t have a proper answer on. Well, at least not an answer that everybody can agree on.

There are some that argue that, while theoretically, loans that allow you to consolidate your debt are good, in reality, they end up giving customers freer cash flow, which often leads to more bad debt.

On the other hand, some people argue that they are good(ish) debt. Although you are borrowing money, you’ve consolidated all of your loans, have a monthly repayment plan sorted out and – importantly – save yourself money in the short term by only paying one set of interest.

Of course, the answer is complicated. If a consolidation loan will help you save money in the long run and reduce your monthly outgoings, it’s good debt. If it’s going to work out more expensive in the long run – or the monthly repayments are more than your combined outgoings from different sources – then it’s considered bad debt.

It’s best to speak to a financial adviser if you’re not sure. A financial adviser will be able to give you advice on whether to consolidate your debt into manageable chunks or to continue paying each debt individually.

If you’re considering a debt consolidation loan, then you can borrow between £1,000 and £8,000 from Bamboo to combine all of your existing debt into one payment, at a rate that matches your credit profile. Representative APR: 49.7%. A guarantee may be required.

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