Most people have incurred debt at some point, whether it be a mortgage, car loan, student loan or credit card debt. However, debt can be an issue if not managed wisely. Too much debt can be financially crippling, and repayment can become difficult.

Debt frequently carries a negative connotation. Upon hearing that someone has debt, many of us often think that said person has poor money management habits. However, it is essential to recognise that not all debt is created equal. Therefore, understanding the distinction between good and bad debt is crucial for making informed financial decisions.

What is good debt?

Good debt refers to any borrowing that is considered an investment in your future, particularly in assets that are likely to appreciate or generate income over time. Good debt is often associated with lower interest rates, manageable payment terms and the potential to increase a person’s overall net worth. Historically, good debt includes student loans, mortgages, and in some circumstances, business loans.

Student loans: investing in education can yield significant returns in the form of higher earning potential. While student loans can be daunting, they often offer long repayment terms and lower interest rates compared to other forms of debt, making them manageable without being overwhelming.

Mortgages: purchasing a home is often considered a crucial step in building wealth. A mortgage allows an individual to acquire property while spreading out payments over an extended period of time. Real estate tends to increase in value. Therefore, each mortgage payment allows you to build equity into your property since part of it goes towards the principal amount of the loan.

Business loans: for entrepreneurs, borrowing money to start or expand a business can lead to substantial returns. A well-structured business loan can facilitate growth, allowing for the purchase of inventory, expansion into new markets, or further hiring of employees. When managed correctly, business debt can contribute significantly to the owner’s overall wealth.

Overall, good debt that is properly managed can be a valuable tool for growth and financial stability, however before borrowing any funds, it is important to conduct a comprehensive cost-benefit analysis prior to ensure you understand the impact of such a decision.

However, there is the ugly side of debt – bad debt.

Over the past 20-plus years, consumerism has become a dominant aspect of daily life. This rise of consumer culture is often propelled by calculated marketing tactics and easy access to credit, which ultimately encourages people to spend beyond their means.

What is bad debt?

Bad debt is typically identified as debt that a borrower cannot repay or debt associated with non-productive assets. This type of debt often arises from loans taken out to finance purchases of things that depreciate in value, such as luxury items, cars, or vacations. In comparison to good debt, which is invested in appreciating assets − such as a mortgage or a student loan − bad debt offers little to no return on investment, and the repercussions of bad debt linger long after the purchase.

Excessive or bad personal debt can have significant and damaging consequences. Below are six potential consequences of having bad debt:

1, Financial strain and increased bills

Bad personal debt often begins and ends with high-interest loans and credit cards. As debt accumulates, monthly payments can become overwhelming, leading to financial strain on the monthly budget. Individuals begin to find themselves in a cycle of only making minimum payments, which prolongs the repayment period and increases the total amount that needs to be repaid.

2, Emotional and psychological stress

The burden of unmanageable debt can lead to significant emotional and psychological stress. Individuals often experience anxiety and hopelessness as they struggle with their financial situation. The constant worry about payment deadlines and collections can lead to sleepless nights and strained relationships.

4, Limited financial freedom

Bad personal debt can severely restrict your financial freedom. When a significant portion of income is allocated to debt repayment, individuals often have little left for savings, investments, or discretionary spending. Moreover, lack of financial freedom often leads individuals to remain in unsatisfactory jobs or career paths simply to meet their debt obligations.

5, Legal consequences

In extreme cases, the inability to manage debt can lead to legal troubles. Bankruptcy can become a last resort for some, leading to a lengthy legal process and long-lasting repercussions, including the loss of assets.

6, Challenges in obtaining new credit

A history of bad personal debt can create obstacles in obtaining new credit. Lenders perceive individuals with a track record of high debt levels and missed payments as high-risk borrowers. This perception can lead to loan applications being denied or approved with unfavourable terms, such as high interest rates or limited borrowing amounts.

Bad personal debt can have long-term consequences, affecting financial stability, mental health, and overall quality of life. Therefore, it is essential to understand the ramifications of debt to either keep yourself on the side of good debt or develop a strategy to manage yourself out of crippling bad debt.

How do you manage yourself out of bad debt? Tamplin (2024) suggests the following strategies:

1, Choose a debt repayment strategy

•Debt snowball method: focus on paying off your smallest debt first while making minimum payments on others. Once the smallest is paid off, move to the next one.

•Debt avalanche method: focus on paying off the debt with the highest interest rate first to minimise overall interest costs.

•Consolidation: consider consolidating multiple debts into a single loan with a lower interest rate.

2, Make a Payment Plan

• Set up automatic payments: to avoid late fees, consider setting up automatic payments for minimum amounts.

•Prioritise payments: allocate extra funds to your chosen debt repayment strategy while maintaining minimum payments on others.

At the end of the day, understanding the difference between good and bad debt is essential. Good debt is designed to support your overall financial growth, while bad debt can often cripple you to the core.

References

Tamplin, T. (2024) How To Get Out Of Debt: 10 Strategies. Available from: https://www.forbes.com/sites/truetamplin/article/how-to-get-out-of-debt/ [Accessed September 15 2024].

• Carla Seely has 24 years of experience in the financial services, wealth management and insurance industries. Over the course of her career, she has obtained several investment licences through the Canadian Securities Institute. She holds ACSI certification through the Chartered Institute for Securities and Investments, UK; QAFP through FP Canada; and AINS through the Institutes. She also has a master’s degree in business and management