Good Debt Vs. Bad Debt
We've probably all grown up thinking that "debt" is a nasty word. Being in debt is bad, isn't it? We may feel we've relinquished a bit of our own personal financial control to a lender who has the upper hand. Incorrect! These days, there are two ways to look at a debt relationship. Let's call them "good debt" and "bad debt". One of them implies positive long-term consequences and the other implies negative ones. We all know for sure which one sounds like the preferred option.
First, let's take a look at the definition of debt. Debt is the amount of money one party owes to another party. You may borrow money to purchase goods or services that you could otherwise not afford to pay for at that particular moment. However, when you borrow, you do so with the promise to repay the funds – with interest – in the future. In this most basic definition, debt may sound neither good nor bad. A closer look at the concept of incurring debt, however, reveals that it could have either positive or negative consequences. The nature of these consequences depends on how you use the money that you borrow.
Good debts open up opportunities to create value or to generate income over time. A couple of examples of good debts are housing loans (mortgages), real estate loans, education loans and business loans. All of these have the potential to help you increase your net worth.
- Housing loan
If you are a permanent resident of Singapore, buying a house may be more financially prudent than renting a place to live. A housing loan (or mortgage) allows you to pay for your home with relatively low monthly installments over a long period of time. This type of debt usually has a lower interest rate compared to other types of loans. In an ideal situation, the market value of your house will increase sufficiently to cover the interest you pay over the course of many years. Aside from the low interest rates, the interest you pay on housing loans is also typically tax-deductible.
A residential property has the potential to increase in value. This means that you may be able to eventually sell you house for much more than you paid for it. Make sure that you look for a house to buy that will have a good resale value, and make some sharp calculations beforehand to ensure that the interest you will pay won't exceed any profit you hope to make when you sell.
Read: Should I Refinance My Home Loan or Keep the Current Loan?
- Real estate loan
Real estate loans may be considered good debts for at least two reasons. Similar to the market value of a house, the value of real estate property has the potential to increase over the years. You can make a hefty profit by reselling the property after just a few years for a higher price than you paid for it. It's also a financial advantage that both residential and commercial real estate can be a great source of rental income.
- Education loan
The path to getting a degree course may cost you anywhere from SGD 10,000 to SGD 15,000 annually. But it's also true that a proper education can significantly boost your earning capacity. Education will expose you to more lucrative employment opportunities which can support repayment of a student loan in just a few years.
- Business loan
A business can be a promising income-generating endeavour. As the owner of a successful business venture, you won't have to rely on another party for your paycheck. Heading up your own business can also motivate you to work harder than ever. However, you do need some working capital to start up or to expand a business. Since a business brings with it a huge potential to build your wealth, borrowing money to start up can be a good idea.
In contrast to all the abovementioned examples of good debts, bad debts are used to purchase or pay for goods and services that have no potential to increase your net worth.
- Credit card debt
Credit cards are most typically used to purchase expendable items whose value deteriorates over time. Some examples of goods and services you may pay for using a credit card are food, clothes, shoes, electronic gadgets and your dry cleaning bill. If you do not pay your credit card balance in full each month, the amount that you are paying for your purchases continues to increase with interest charges even as the market value of your purchased items goes down.
Nevertheless, using a credit card is not necessarily to be discouraged. The main thing is that you manage your monthly payments properly and avoid the high interest charges that an unpaid balance brings with it.
- Car loan
Vehicles are generally not considered assets but rather liabilities. Vehicles quickly depreciate and continue to lose their value over time. However, there may be some cases where a car loan may be considered a good debt. If the vehicle being financed is used for an income-generating purpose such as a business, then the car loan may be able to pay for itself.
Now that you are armed with an understanding of good and bad debt, try to determine which kind of debts you currently have. There's a lot of useful information on the different types of debts and loans available in Singapore to be found here.
This article first
appeared on The New Savvy.