Debt often gets a bad rap. It’s easy to think of it as a burden that weighs you down, but the truth is, not all debt is bad. Some types of debt could actually be a stepping stone to financial growth, potentially helping you build wealth, secure assets, or invest in your future.

The key is knowing the difference between "good" debt and "bad" debt. In this article, we'll break it down, provide real-life examples, and help you work out whether taking on debt is a smart financial move. Let’s get into it.

What is good debt?

Good debt is the kind that works in your favour. In other words, it has the potential to grow your wealth or improve your financial position in the long run. Rather than being a money drain, good debt is an investment in your future.

What makes it "good"?

Good debt usually ticks the following boxes:

• It helps you acquire appreciating assets. If what you're borrowing for is expected to increase in value over time, the debt could be considered good.
• It has a clear return on investment. If taking on this debt enables you to earn more money in the future, it may be a beneficial financial decision.
• It is affordable. Good debt generally comes with reasonable interest rates and manageable repayment terms that align with your financial situation.
• It provides long-term benefits. The debt should contribute to your financial wellbeing over time, whether through income generation, capital growth , or improved earning potential.

Examples of good debt

1. HECS-HELP

Getting an education can significantly boost your earning potential. While student loans like HECS-HELP do create debt, they enable people to gain skills and qualifications that may lead to better-paying jobs. In Australia, their interest rates are usually tied to inflation, and repayments only kick in once your income exceeds a certain threshold.

2. Home loans (mortgages)

A mortgage allows you to buy a home, an asset that typically appreciates over time. Owning a home may also provide stability and financial security compared to renting indefinitely . However, it's crucial that you ensure your mortgage rates are within your power to repay.

3. Real estate investment loans

Borrowing to invest in real estate could be a smart financial move if the property generates rental income and appreciates in value over time. Much like with #2, though, it pays to be conservative with your rates of repayment.

What is bad debt?

On the flip side, bad debt is the kind that drains your finances instead of helping you grow them. It often funds purchases that quickly lose value or don’t contribute to your financial future.

What makes it "bad"?

Bad debt usually has these red flags:

• It’s used for depreciating assets. If what you’re borrowing for loses value quickly, it might not be a wise financial move.
• It doesn’t generate income or wealth. If the debt is purely funding consumption with no long-term benefits, it’s a liability.
• It carries high interest rates. Many types of bad debt, such as credit card debt, come with sky-high interest rates that can make repayment a real struggle.
• It creates financial stress. If a debt makes it harder to pay your bills or save for the future, it’s probably bad debt.

Examples of bad debt

1. Credit card debt

As mentioned above, credit cards often carry high interest rates. Using them for everyday purchases without paying off the balance can lead to a cycle of financial stress and long-term debt accumulation.

2. Personal loans for non-essential items

Borrowing money for holidays, luxury items, or expensive gadgets can quickly lead to financial problems if you are unable to pay it back quickly.

3. Car loans for expensive vehicles

Cars depreciate rapidly. Taking out a large loan to finance a car beyond your means can leave you paying interest on an asset that continually loses value.

4. Buy now, pay later (BNPL) purchases

BNPL services can encourage overspending and lead to financial difficulties if payments are missed or accumulated across multiple purchases.

How can I tell if debt is good or bad?

If you're unsure whether a particular debt is a wise decision, consider asking yourself these questions:

1. Will this debt help me build wealth or improve my financial situation over time? If the debt contributes to future financial growth, such as property ownership or education, it could be worth considering.
2. Is this debt financing an appreciating or depreciating asset? Assets that grow in value, like some real estate, are generally considered good debt, whereas cars and consumer goods typically lose value.
3. Am I borrowing for something essential or something I simply want? If the debt is for something necessary, like medical expenses or education, it may be justifiable, whereas luxury purchases might not be worth it.
4. Can I comfortably afford the repayments without financial strain? If making repayments will put pressure on your budget or force you to cut back on essentials, reconsider taking on the debt.
5. What is the interest rate, and how much will this debt cost me in the long run? Higher interest rates mean you’ll pay significantly more over time. Always calculate the total cost before committing.
6. Do I have a clear repayment plan? Without a structured repayment plan, debt can spiral out of control, leading to financial hardship .
7. Would I still take on this debt if I had to pay for it in cash upfront? If the answer is no, you may want to reconsider whether the debt is necessary.
8. Am I borrowing to invest in my future or to fund my current lifestyle? Debt should ideally be used for long-term benefits, not short-term gratification.

By answering these questions honestly, you can better assess whether the debt you’re considering is an investment in your future or a financial burden in disguise.

When bad debt is unavoidable

It’s easy to say “just avoid bad debt,” but sometimes, that’s simply not realistic. Life happens, and there are times when borrowing money is the only way to get by. Whether it’s covering emergency medical expenses, dealing with an unexpected job loss, or making ends meet during tough times, sometimes bad debt is necessary.

If you find yourself in this situation, here are some ways to manage it effectively:

• Prioritise high-interest debt. Try to pay off high-interest loans first to minimise long-term financial strain.
• Create a repayment plan. Even small, consistent payments could help reduce debt over time.
• Seek financial support. Many financial advisers , government programs, and non-profits offer assistance to those struggling with debt.
• Avoid taking on additional debt. Whenever possible, try to avoid accumulating more debt while working towards repayment.

Recognising that not all bad debt is avoidable allows for a more balanced and realistic approach to financial management.

Wrapping it up

Debt isn’t necessarily bad – it’s all about how you use it. Good debt can be a powerful tool for building wealth, improving financial stability, and opening up new opportunities. On the other hand, bad debt can quickly become a financial trap, making it harder to achieve your long-term goals. That being said, sometimes bad debt is unavoidable, and that’s okay.

Before taking on any new debt, take a step back and evaluate whether it aligns with your financial future. Smart borrowing decisions can set you up for long-term success, while careless debt choices might set you back years. The key is to stay informed, borrow responsibly, and always consider the long-term impact of your financial choices.

As always, do your own research and seek financial advice if you’re unsure. Managing debt wisely is one of the most important steps in achieving Financial Independence.

Happy investing!