We have all heard stories of people falling into debt traps. There are individuals caught in situations which have spiralled out of control, and others who rely on their income to finance their lifestyle only to find themselves deep in debt when they unexpectedly lose it. As a result, the word ‘debt’ tends to carry a negative connotation, while frequently inciting feelings of fear, panic, and dread.
However, there are certain types of debt that can be considered an investment while helping to increase your overall financial position. Debt is often classified into two categories: good debt and bad debt. It is important to understand that the categories are not based on how you feel about taking on the debt, but rather how it affects your credit reputation and finances. Understanding the difference between good and bad debt can help you to make better financial decisions.
Getting Into Good Debt
Good debt is generally defined as debt that creates positive returns and helps you to build value over time. The outcome tends to justify borrowing the money. It is a great tool to help you deal with big ticket items that may be difficult to achieve such as buying your first home, furthering your education, building an investment portfolio for retirement, or starting a business. For example, when you purchase a house, you are doing so with the expectation that the asset goes up in value over time.
At the same time, incurring this debt instead of making an upfront payment could prevent a strain on your cash flow or the risk of wiping out your emergency funds. Taking out an education loan is also seen as good debt, as it is helping you work towards a brighter financial future – a higher paying job and better employability down the road.
If properly managed, credit cards can also be a form of good debt for many people. Once you are in the habit of making on-time payments, you increase your cash flow and consumer protection when you purchase larger goods such as furniture. You can also benefit from the many credit card offerings like discounts and cash back without worrying about overspending.
The beauty of good debt is that it is essentially a vehicle towards financial independence. That said, remaining in control of your debt and having the ability to pay it off in full is still crucial to gaining good financial health and respectable credit.
Losing Value Over Bad Debt
Bad debt is incurred when you purchase an item that loses its value over time and does not generate long-term income.
Bad debt can be a problem when you only make the minimum payment each month on your credit cards while maxing them out and juggling several cards at once. This can result in an endless cycle of outstanding debt that never gets resolved. Not only will it be difficult to pay off your bill, the compounding interest you have to repay will be much higher, thus lengthening your payback timeframe.
Note: Default records stay on your credit report for 3 years upon full or negotiated settlement, while bankruptcy data is retained for 5 years from the date of discharge from bankruptcy.
The Quickest Way to Turn Things Around
The quickest way to get into good debt is to pay off your bad debts as soon as possible. At the same time, reduce your necessary debt to a comfortable level. As lenders like to see plenty of breathing room between the amount of debt reported on the credit facilities and total credit limits, pay off your outstanding debts to improve your credit score. This could be as simple as paying more than the minimum amount each month.
Also, check your credit report at least twice a year to ensure that the information reflected is updated. With this information, lenders will be able to decipher if you have made full payments on your monthly bills and also be aware of your total outstanding debt. These days, even a simple credit card application requires lenders to pull out your credit file. As such, it’s important to maintain a healthy score by keeping good repayment habits.
Many of us tend to overthink credit, but it is that simple. There are only two main points; prioritise what is important to you and commit to repaying your debts on time, all the time. As long as you practice these things, you are well on your way to only having good debt.
If you have applied for a new credit facility in the last 30 days with any of CBS’ member banks, you can receive a complimentary copy of your credit report from CBS. Otherwise, you can purchase your report online to understand your credit report better.