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Understanding...good debt vs bad debt

April 16, 2024
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Finsesh
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Finsesh

Clarifying good and bad debt

Understanding how the economy works will give you a better perspective of why debt is such a  menace in society. As companies want to continue selling their products, they are willing to sell on credit. This means you and I borrow money to buy their products, increasing the company's bottom line. Retailers do this, banks, car manufacturers, etc, to an extent that it has become the norm. Most people don't have the basic financial literacy to distinguish between good and bad debt, which affects their personal finances and their bottom line. 

In South Africa, our debt to income ratio for the average South African is at 67% according to the latest Trading economics statistics. This means that debt has made the average South African a modern-day slave to their job, as they need to work to continue to repay their debt. 

We will draw a line between good and bad debt and help you understand that money can work for you, and you don't have to work for your money. 

 

Good debt vs bad debt

Good debt: Good debt is debt to be spent on something that will increase your net worth over time. Good debt becomes even better debt when you have other people repaying the debt for you and is generally a result of an income-producing asset. Good debt is a way for money to work for you.


 

Some examples of good debt:

  • Investment properties: Using the bank's money to buy yourself an income-generating asset is probably one of the best ways to use leverage. Over time your tenant repays your debt for you, and you end up with an asset that costs minimal from your pocket, providing an income for life. Your primary home is seen as natural debt as you are buying an asset but it's a non-income generating asset, which means you are repaying all the expenses and mortgage repayments from your pocket. After all capital growth and expenses, you will most likely be in a net-worth neutral state. 
  • Business loan: Using debt to fund a business is riskier than funding investment property, but if the business has a sound business model and the business is successful then it will add value to your net worth. If the business fails then this good debt will become bad debt and you will have to make all the repayments from your pocket. 
  • Student loan: Tertiary education is expensive and can only be afforded by a few. Most people will resort to student loans and repay them through their young working careers. If the course of study is completed successfully and the income from your job is sufficient to repay the debt, then it can be seen as good debt. If you made course changes or spent money on a low-income generating degree then this will be bad debt as you will have to repay the debt from your pocket or struggle to repay the debt. In the perfect world, you want to use loans to get an education in a high-paying career and repay the loan as soon as possible. In this ideal world, you used leverage to acquire your 9-5 superpower, the most powerful wealth-building tool for the man in the street. 


 

Bad debt: Bad debt is debt that does not generate an income or increase your net worth and reduces your ability to create wealth. Bed debt requires you to repay all the debt plus interest from your pocket. These loans fund our lifestyles like vehicle loans, personal loans, retail debt, or any line of credit. Bad debt forces you to work for your money making you a modern-day slave.


 

Examples of bad debt: 

  • Vehicle loans: If you need a vehicle to get to and from work and the vehicle is modest and within your ability to afford it and can be repaid under 3 years with no balloon payments, then a vehicle can be seen as good debt. For the most part, vehicle finance is used because people want the vehicle and not because they need it. Placing them in deep debt that detracts from their wealth-building opportunities and net worth.
  • Personal loans: Personal loans are mostly used for large purchases and emergencies. This expenditure will have no future benefit to your net worth and is seen as bad debt. At an interest rate between 18.25% and 26.5%, this loan will dig you deeper into debt sooner than you think. 
  • Retail debt: Buying clothes that you can't afford to buy in cash is a good example of bad debt. It's not that you need it, but you want that jacket. The jacket does not add any value to your net worth but you have to repay the price of the jacket plus interest averaging 17.5% in South Africa.  

 

Reassess your debt

Do a review of your personal finances to determine what kind of debt you have. If the debt is detracting from your net worth, then it's bad debt and you should prioritise getting rid of it. If it adds value to your net worth, keep on servicing the debt and use it to make yourself wealthier. 

The key to financial freedom is a person's ability to convert earned income into passive income, by avoiding debt, spending less than you earn, and investing the rest.

Onward to Financial Independence 

If you found this blog post helpful please follow us on Facebook and Twitter @finsesh for more tips on Financial independence.


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