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Understanding ‘Good’ Debt and ‘Bad’ Debt

If borrowing gets excessive, it could snowball into a debt trap. That’s why it is important to keep your debt under control by separating the good from the bad ones.

Debt has become part of life. Thanks to overzealous marketers and unending wants, an average Joe repays one loan or the other at a point in time. If borrowing gets excessive, it could snowball into a debt trap. That’s why it is important to keep your debt under control by separating the good from the bad ones. 

What’s a good debt?

Good debt is exemplified in the adage “it takes money to make money." If the debt you take helps you generate more income from your investment or through its growth in value, then it is a good debt. Typically, they carry relatively lower rates of interest. 

For instance, home loan is the cheapest category of loans available in the market and when one factors-in the tax benefits, it works out to be quite economical. Moreover by buying a house, you also own an asset – that might appreciate in value over a period of time.  

Education loan is another example. If you select well, it has the potential to boost your earning capacity and recover your investment in a short span of time. 

Good debt is exemplified in the adage “it takes money to make money." If the debt you take helps you generate more income from your investment or through its growth in value, then it is a good debt. Typically, they carry relatively lower rates of interest. 

Risks of Good Debt

However, too much of a good thing is bad. Often, people extend their budget to buy a house that they cannot afford. Over-stretching your finances could leave little money for meeting your other important financial goals as well as contingency situations. So, make down payments for at least 20% of the property value and limit your home borrowings to the minimum.  

Similarly, while taking education loans ensure you research its scope and job opportunities, and the probable career progression. Don’t borrow more than a year of your expected first year salary. 

What’s bad debt?

Bad debt is any debt you take to own depreciating assets. If the asset you buy from the debt won't go up in value or generate income, you have resorted to bad debt. 

Taking a loan to buy a car is an example. The value of the car depreciates by 15%-20%, the day you drive it home from the showroom. 

Similarly, credit card debt, consumer loans and personal loans are not ideal. Buying high-end TVs that one can’t afford with a consumer loan is not a smart financial move. Credit card debt if paid on time gets you free credit. But once you start delaying payments, it becomes bad. 

Don’t pay bad debt with good debt

Often, people mortgage their homes to borrow more and buy a car or repay other debt. It gets them loans at lower rates. However, it’s not smart. In such loans your house is kept as collateral. Any default in its repayments will result in you losing your house. Secondly, it will elongate your repayment period (with its inherent risks). 

While one can consolidate multiple debts – especially if one is cheaper than other, doing so with home loans can risk your most priced asset. 

Watch your debt-to-income ratio 

Also keep an eye on overall debt. It will affect your credit score and the ability to borrow at cheaper rates. As a thumb rule, ensure all EMI payments put together is limited to 35% of your take-home salary. 

Final word

While the hardliners might interpret all forms of debt as bad, there are some good ones. However, don’t look for instant gratification and take a loan only to improve earning potential or to invest in your future. Keep debt within limits without affecting your savings towards important financial goals.

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