Bayport Blog

Good debt vs bad debt: know the difference before you take out a loan

In simple terms, good debt is a personal loan you can afford and that you use to buy things that you need. Bad debt is a loan you cannot afford and that you use for things that you do not need.

Bad debt is bad because it does not add lasting value to your life. In fact, it destroys value by burdening you with payments you cannot afford, As you are likely to default, your credit score is also likely to suffer.

Good debt, on the other hand, helps you to build value and improve your life by, for example, education, getting the medical care you need, or buying or fixing an asset, such as your house or your vehicle.

Furthermore, when you borrow responsibly and manage your personal loan wisely, your credit record benefits, which is important. You will need a healthy credit score if you need another loan, or want to enter into a rental agreement or even a cellphone contract.

How to make good borrowing decisions

The starting point is asking yourself if the thing you need money for, is something you want or something you need. Needs and wants are not the same.

For example, you might really want a fabulous new pair of shoes because they are all the rage. But you already have lots of shoes and you don’t even wear all of them. The fact is that you will be fine if you don’t buy these ones, and chances are that if you take out a loan to buy the shoes, you will be dealing with the debt long after you no longer wear them.

On the other hand, if your only pair of shoes are falling apart, you definitely need new shoes. It is still not a great idea to take out a loan to buy shoes, but if decent footwear stands between you and keeping your job, the loan makes sense.

Once you have established that you have to take out a loan for something you really need, determine how much you have to borrow. It can be very easy to take out the maximum amount you qualify for so that you have some money left after the “need” to buy a “want” or two. This is not a clever strategy. Only borrow the exact amount you need so that you can repay the loan as quickly as possible, and keep your risk of defaulting as low as possible.

The next step is to work out how much you can afford. Here the loan interest is very important. Remember that you don’t just have to repay the amount you borrow; there is also interest as well as other costs like admin fees. You have to make sure that you can afford the full loan before you decide to borrow.

Before you even approach a credit provider, spend time with your personal budget. Make sure you know exactly how much money comes in every month and how much you spend. Can you cut down on your expenses to afford the loan repayments? If not, you cannot afford to borrow.

Now that you know how much you need to borrow and how much you can afford, research your options.

Only ever take out a loan from a registered credit provider so that you do not fall victim to reckless lending.

Be careful to not fall for special offers, such as “no interest for 12 months”, without doing your homework. You have to understand the implications of the offer and look at the loan in its entirety before you sign the loan agreement.

Speaking of the loan agreement: do not sign anything unless you fully understand every word in the contract. Ask as many questions as you need to – it is the agent’s job to explain everything to you. Countless people end up in a debt trap because they sign contracts that they don’t fully understand.

Knowing the difference between good debt and bad debt, and making the smart money decisions that keep you away from bad debt, is extremely important. Always make sure that your personal loans add lasting value to your life, instead of just a bit of fun.