Good debt vs bad debt

Can being in debt ever be a good thing?

From home loans and credit cards to student loans and Afterpay, there are myriad ways to accumulate debt.

But is being in debt necessarily a bad thing?

RACQ Financial Advocacy Analyst Nathanael Watts said all debt came with a level of risk, regardless of whether it was considered good or bad.

“When you take out a loan you’ll almost always end up paying back more than you borrowed in the form of interest,” Mr Watts said.

“Having to make loan repayments also reduces your cashflow so it’s important to ensure you have enough money after paying your loan to live comfortably.”

Good debt

Mr Watts said good debt was debt that could be used to improve your financial situation.

“Good debt should allow you to make money or save money,” he said.

Investment or business loan

Mr Watts said investment or business loans were generally considered good debt as they used money to make money.

“Many people have grown their wealth buy using investment loans to purchase an investment property or a business,” he said.

“Business loans can also be an effective way to help grow a business provided it’s used in a way that is profitable.

“If you’re using the loan to fund a business or investment that’s making a loss then it becomes a bad debt that’s costing you money.”

Student loan

Mr Watts said student loans, such as government supplied HELP, HECS and VET FEE-HELP, were good debts as they were investment in yourself.

“Student loans can help you open up a range of career options provide the ability to earn more money throughout your career,” he said.

“They’re interest-free (indexed to inflation) and there’s no timeframe to repay the loan – you only have to start repaying the loan when you start earning a certain amount of money each year.

“The loans are also cancelled if you die so there’s no risk of passing your debt on to your family.”

Owner-occupier home loan

Mr Watts said an owner-occupier home loan was another form of good debt.

“A home loan doesn’t make money, but it’s still considered a good debt as can provide future stability,” he said.

“If you’re an owner-occupier you don’t need to pay rent and you’ll end up with somewhere to live when you reach retirement.”

Mr Watts said mortgage stress could turn a home loan  into a bad debt.

“If you borrow more than you can comfortably afford to repay and don’t have enough money left over after loan repayments to live comfortably, your debt becomes bad because it isn’t helping you to make or save money,” he said.

Bad debt

Mr Watts said bad debt ended up costing money.

“Bad debt is used for things that have no lasting value or depreciate in value, so it ends up costing you money instead of making money,” he said.

Personal loans

Mr Watts said personal loans could be a bad debt if they involved spending money you did not have on things that you wanted rather than needed.

“If you book your dream holiday with a $20,000 loan you’ll actually end up paying more than $25,000 when you factor in interest over five years at an average rate of 9.4%,” Mr Watts said.

“If it takes you five years to pay off a four-week holiday you’ll still be making payments 59 months after you get back”.

Credit card debt

Credit card debt is easy to accumulate and can encourage you to buy things you don’t really want or need with money you don’t have,” Mr Watts said.

“You can also expect to pay up to 25% interest if you don’t pay your credit card off within the interest-free period which means your purchases can end up costing you a lot more than what you paid at the cash register.”

Payday loans

Mr Watts said payday lenders – such as Nimble, Wallet Wizard and Cash Converters – often target vulnerable people.

“Unexpected expenses, such as car repairs or medical bills, can sometimes make it hard to make ends meet and you may be tempted to take out a short-term loan to tide you over until payday but these loans can easily turn in to a debt trap,” he said.

“The Australian Government requires payday lenders to include a warning on their website about the expense and pitfalls of borrowing small amounts of money. 

“Anyone considering using a payday lender should follow the suggestions listed in this warning. 

“This type of lending should only be used as a last resort if absolutely necessary.”

Car loans

“Car loans should be avoided if possible,” Mr Watts said.

“Cars depreciate the minute you drive out of the dealership so the total amount you pay, including interest, will often end up being much more than the car is worth by the end of the loan.”

Buy now, pay later

Mr Watts said buy now, pay later (BNPL) services – such as Afterpay and Zip Pay – encouraged poor spending habits.

“You’re essentially borrowing money from future paycheques which means you’ll have less money over the eight weeks it takes to pay off your BNPL loan,” Mr Watts said.

“If you have multiple BNPL loans it can significantly impact your finances and if you don’t make repayments on time you can end up paying hefty penalty fees.”

The information in this article has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in the document is general advice and does not take into account any person's particular investment objectives, financial situation or needs. Before acting on anything based on this advice you should consider its appropriateness to you, having regard to your objectives, financial situations and needs.