How to know the difference between good and bad debt

Many South Africans live with debt, which can negatively affect their finances. However, not all debt is harmful.

It’s essential to recognise the difference between good and bad debt and their impact on your financial health.

How to understand debt

Debt can either help you grow your money or erode your wealth, so it’s essential to understand how different kinds of debt will affect you.

Some types of debt, such as a home loan, can improve your financial prospects, providing you with an asset that will increase in value.

However, a personal loan or credit card debt may have the opposite effect, encouraging you to consume rather than invest. This is especially true if you use a loan or credit card for everyday needs such as groceries, utility bills, rent, etc.

If not managed responsibly, these types of debt can worsen your financial situation, especially if you start to rely on further debt to get out of debt.

What is “good debt”?

Good debt refers to money borrowed to purchase assets that will appreciate and possibly generate income in the future.

The following types of good debt can help secure your long-term financial stability:

A home loan

Since real estate values usually increase over time, buying a house is often considered a wise financial decision and a prime example of good debt.

A student loan

Although a student loan exposes you to short-term debt, it can lead to a higher-paying job and better career prospects, so it can be seen as an investment in your future.

A business loan

Used sensibly, a business loan can help you expand your enterprise or boost company earnings.

Using debt responsibly 

If the above types of debts are controlled and well-managed, they will help build your financial portfolio in the long term.

Using debt responsibly helps you reach your goals and, over time, increase your net worth – meaning, the value of your assets minus your liabilities. Your net worth provides a good “snapshot” of your financial position.

The advantages of good debt

Well-managed debt can be an investment in your future financial stability.

You can acquire assets, start a business, improve your skills, and invest extra funds, all of which may help you to create wealth in the long run.

What does “bad debt” refer to?

Bad debt is unproductive debt – that is, debt that doesn’t add meaningful value to your life.

You might enjoy buying branded goods, the latest cell phone, expensive furniture, or a car that serves more as a status symbol than a practical vehicle. However, the value of these items depreciates quickly, and they do little to enhance your financial security.

You incur bad debt when you pay for lifestyle choices that don’t give you a return on your investment. Debt can escalate when you live beyond your means, and take on even more credit to pay off existing debt.

Debt management – taking control of your finances and planning to pay off your debt – can help you reduce the burden and prevent future financial difficulties.

Credit card debt

Getting a credit card is fairly straightforward, but the cost of borrowing is often high. For example, your credit may lend to you at a high interest rate.

This is because credit card debt is unsecured – there is no underlying asset, such as a home or car, that a lender could seize if you default on your payments.  

Credit card debt is one of the most expensive types of debt in the market, particularly if you don’t pay the minimum amount owing on time and in full.

Using your credit card irresponsibly can quickly trap you in a debt cycle. However, when used responsibly, a credit card can help you buy items you need without leaving you cash-strapped.

Short-term loans

The interest rates on short-term loans – such as payday loans – are usually very high. Many short-term loans also have high fees attached to them, increasing the cost of borrowing.

Short-term loans also tend to have short repayment terms, making it difficult to repay your debt in full.

These factors make it a challenge to avoid accumulating debt.

Personal loans

People often use personal loans to consolidate debt, make large purchases such as cars, furniture, or electronics, pay unexpected medical bills, or finance home improvements.

Buying items that aren’t strictly necessary can strain your finances, and the high interest rates charged on personal loans can make your debt expensive.

What happens when you have bad debt?

Bad debt hurts more than just your bank account. It can lead to stress and anxiety, affecting your physical and mental health.

It can also impair your credit score, making it harder for you to access credit or be granted a loan in the future.

How to distinguish between good and bad debt

The key to distinguishing between good and bad debt lies in understanding the purpose of your debt and the terms associated with it.

Good debt helps you obtain an asset – or education – that can help you generate income or has the potential to appreciate in value. The benefits are often long-term, so you won’t always see this value immediately.

Good debt generally attracts reasonable interest rates, meaning repayments should be manageable and not affect your financial stability. By contrast, bad debt comes with high interest rates, short-term benefits, and possible financial difficulties in the future.

Always consider whether any debt you take on will help you grow financially or become a burden.

The role of interest rates in debt management

Lower interest rates typically mean debt is less costly over time, which is often the case with good debt, such as a home or student loan. Bad debt, such as a payday loan or unmanageable credit card debt, usually comes with high interest rates.

Managing your interest rates effectively – by refinancing or consolidating debt, for instance – can help you keep debt under control.

Strategies to manage and pay off bad debt

If you struggle with bad debt, it’s crucial to act fast. Start by creating a budget that prioritises debt repayment, focusing on paying off high-interest loans or credit first.

Consider consolidating your debts into a single, lower-interest loan. This can simplify your payments and reduce the overall interest you pay.

Consider other debt reduction strategies, too, such as cutting unnecessary expenses, increasing your income through a “side hustle”, or speaking to your creditors about renegotiating your debt. This will free up more money to service your debt.

The impact of debt on your credit score

Manage your debt wisely so your credit score is not compromised.

Pay your bills on time, resist the temptation to spend to your credit limit, and try not to skip payments. Reach out to your creditors if you think you can’t meet your financial obligations.

If you live beyond your means, and don’t have enough money to cover your debts and your living costs, you’ll encounter financial difficulty. It’s difficult to get on top of bad debt, which is why it’s essential that you take steps early on to manage the situation.

Being financially responsible may be difficult at times as you may sacrifice something you want. However, if you exercise patience, you’ll build up a good credit record, which will mean lenders are willing to extend you more credit in time.

Reducing your debt ultimately helps you to achieve your financial goals.

Seeking professional help for debt management

If you’re overwhelmed by debt, it may be time to seek professional help.

Some advantages of professional help include financial guidance, practical support that can reduce your stress, and education about managing debt and improving your credit score.

This helps you make better-informed decisions and avoid financial difficulties in the future.

DebtBusters: Your partner in debt management

DebtBusters offers debt counselling services, including tools and strategies to help you manage and overcome debt, and get your finances back on track. Your debt counsellor can assist with budgeting, debt consolidation, and negotiating with creditors.

Debt review and debt restructuring are also options that can help you manage your debt more effectively, providing relief and a clear path forward.

Watch this video.

Steps to take if you’re struggling with debt

Recognising unmanageable debt is the first step toward recovery. If you skip payments, feel overwhelmed, or rely on credit to get by, it’s time to act.

Start by assessing your financial situation, creating a budget, and cutting unnecessary expenses.

Contact DebtBusters for professional assistance. Our counsellors will help you to manage and reduce your debt.

Financial education

Financial literacy empowers you to make informed decisions about your money, which can prevent you from falling into unsustainable debt.

There are many resources available to educate you about personal finance, from online courses to workshops. These will help you to understand how debt works, how different loan types can affect you, and how budgeting allows you to avoid the pitfalls of bad debt.

It’s never too late to turn your financial situation around. DebtBusters can provide the support and guidance you need to take control if you struggle to manage your debt. Contact us today to find out more about debt counselling and debt consolidation.

FAQs

What are some signs that I have too much bad debt?

Warning signs include relying on credit cards for essentials, missing payments, and feeling stressed about your financial situation.

Your debt-to-income ratio can be a helpful indicator of whether you have too much debt. Calculate this ratio by dividing your monthly debt payments by your monthly income.

For example:

• Monthly debt payments / gross monthly income = R3,000 / R10,000
• Debt-to-income ratio = 0.3

Your debt-to-income ratio is 30%. This means that 30% of your income is used to pay off your debts.

You should ideally keep your debt-to-income ratio under 35-40%.

How can DebtBusters help me manage my debt?

DebtBusters can help you understand the difference between good and bad debt and restructure your debt to make it easier for you to manage.

A debt counsellor can also explain the mechanics of debt counselling to you.

Can good debt ever turn into bad debt?

Yes, if good debt is mismanaged. For example, if you miss payments on your home loan, it can quickly turn into bad debt. Your financial behaviour determines the outcome as much – or more – than the type of loan itself.

How do I know if I need debt counselling?

If you know you’ll struggle to meet your financial obligations (i.e. can barely come out on your salary while paying your debts) and feel overwhelmed by debt, you may need to consider debt counselling.

What steps can I take to avoid falling into bad debt?

Educate yourself about financial management, budget effectively, and avoid high-interest loans.