What is Debt, And What Makes It Good or Bad?

What is Debt, and what makes it good or bad?
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Last Updated on by Tree of Wealth

By definition, a “good” debt is when the purpose of getting the loan can outweigh the overall amount of the loan, interest included. Examples of good debts would be business loans; using debt to expand the business to earn more profit, housing loans; buying a house with an affordable mortgage as the overall value of the property increases over time, and college loans; the ability to earn a sizable income with a bachelor’s degree. However, there are no guarantees that these scenarios can happen to everyone that takes these kinds of loans in the world today.

You may be familiar with the two categories of debt: good debt and bad debt. Loans that are used to build up income or increase a person’s wealth is generally considered as “good” debt, such as the examples given above. On the other hand, any debt is “bad” debt if the loan taken does little to nothing to improve a person’s financial status, such as credit card debt and any other types of consumer debt.

These definitions may be true to some extent, but it oversimplifies the two kinds of debt. In reality, there are a lot more variations between the two.

While mortgages and student loans can be utilized to build up wealth and even increase a person’s income, this isn’t always the outcome, and others may find a harder time capitalising on their mortgage or landing a good paying job even with a college degree. In these cases, the “good” debt they have isn’t giving them the best returns.

In the world we live in today, having some sort of debt is generally considered a good thing. How a person manages his or her debt to build a good credit history can be the defining factor when making big-ticket purchases like housing properties and cars. This is why having more “bad” than “good” debt isn’t exactly an overall bad thing, as bad debt can still be used to build up a good credit score.

That being said, not all debt is created equal, and that you should consider what taking any type of loan entails you financially.

How do you define a loan?

As a rule of thumb, any debt incurred with the purpose of increasing a person’s net worth or has the potential to increase its future value is considered to be good debt. And any debt incurred without the capacity for it to pay for its own is generally bad debt.

Now that we know the basics of what is good and bad debt, the next thing you would want to consider is “how much debt is too much?”

There are a number of ways of finding out whether you have incurred too much debt you can financially handle. A reliable financial metric is computing your debt-to-income ratio. You can do this by adding all your monthly debt payments and dividing it by your monthly gross income. Generally speaking, the lower your debt-to-income ratio is, the better your financial capacity will be.

For instance, if you’re paying for the following monthly; S$1,500 in mortgage, S$300 in credit card debt, and S$200 for your car loan. That brings you up a total monthly debt of S$2,000. If you have a monthly gross income of S$4,000, this would mean that you have a Debt-to-income ratio of 50%, which is not a good place to start thinking of getting another loan.

Most lenders consider a debt-to-income ratio higher than 43% as a red flag. Statistically speaking, borrowers with 43% debt-to-income ratio or higher tend to be bad loan payers as they struggle to come up with the amount to pay off their debt on a regular basis.

What makes debt “good”?

To put in simpler terms, a good debt is any debt incurred that adds potential in increasing your overall net worth or increases your monthly income. A good debt is an investment for your future. Usually, the amount of a good debt can be quite steep and paid over long periods of time, but this kind of debt can be used as leverage for more financial success in the future.

As an example, you borrow S$1.3 million for a house valued at S$1.6 million, the balance you pay out of pocket. The amount you borrowed will be paid off in 30 years, with an interest rate of 1.15%, this will bring your monthly repayments to around S$3,900

Looking at the monthly repayments alone can make almost anyone back off from the offer. However, a wise property investor would look at it as a great investment opportunity. Seeing how much he or she has to pay monthly on the mortgage, the investor can set the property for rent at around S$7,000 monthly to generate a monthly income of at least S$3,100 while letting the property pay for its own mortgage.

Using the same example as above- in 30 years, when the owner fully paid for the mortgage, the appreciated value of the property could have risen up to around S$2.5 million. This would mean that if the owner indeed opted to sell the property after paying off the loan, he or she would have profited over a million, on top of the monthly rental income he or she has been earning over the past 30 years.

Getting a loan for a property with the mindset of renting it and then selling it off for profit is an example of debt which pays for itself with profit to top it all off.

A good debt is an investment because it’s a form of debt that can pay for itself, principal and interest included- with the debtor getting away with more money than owed. More examples of debt that can pay for itself plus more are asset investments such as stocks and bonds.

Good debt can allow people to manage their finances more efficiently by letting them purchase stuff in case of  unforeseen emergencies. Taking out a loan for a mortgage, purchasing stuff that effectively saves you time and effort, buying living essentials, investing for our education through student loans or to simply pay off existing debt through consolidated debt. These things may seem to put you on a tight financial spot early on, but greatly pays off in the long-run.

Good Debt Examples

1.    Mortgage Loans and Real Estate Investments

To further expand the example above, mortgage is the giant of all forms of debt. Mortgage can allow the borrower to live somewhere with the potential to increase its market value over time.

Applying for a mortgage to pay for a roof over your head is generally considered to be good debt. A house can almost always increase its overall value through the years, providing a safe space while improving the homeowner’s net worth.

Historically speaking, mortgages are considered to be the safest form of good debt, despite the amount of loan the borrower incurs as any amount paid is converted into equity for the debtor.

Home equity to this day is one of the safest and accessible ways to build one’s net worth. However, mortgages require an understanding of how much one can borrow, as well as the time and effort one has to put in studying the real estate market to make sure he or she is not overpaying for the property they’ve invested in.

A good ratio to consider is that the monthly mortgage payment, including any private mortgage insurance (PMI), should be less than 28% of your gross monthly income to not stress yourself financially paying off for the mortgage.

To maximize the profitability of your mortgage, consider converting the property as a real estate investment. Some property investments include the following profitable steps:

  • Buying properties to sell at a profit
  • Monitoring real estate appreciation
  • Putting up a business within the property such as a café or laundromat
  • Renting out the property

Any of the examples mentioned above can decrease the chance of turning your mortgage into bad debts. If done correctly, the property could even have the potential to pay for the mortgage itself while generating enough income to keep some of the profit for yourself.

In today’s economy, real estate value appreciates a few percent on a yearly basis. This means that if you were to buy a home today, you’ll get a chance to sell it off at a higher value than your mortgage after you’ve completely paid for it.

2.    Student Loan Debt

A university degree can be quite costly and this is where educational loans come into play. A bachelor’s degree can open up career opportunities that can repay the education loan you’ve gotten for it many times over. As an example, a law degree may cost you a ton of money in student loans, but once you’re a lawyer, you can easily pay for the education loan you got for the degree within the first 5 years into your career.

Student loans are one of the most common forms of good debt as the cost of going to school has risen over the years, families and individuals struggle to get a degree paying for school out of pocket. As the cost of education rises, the salary for bachelor’s degree holders rises as well. Here are some points to consider why educational loans are good debts:

  • Student loans have lower interest rates
  • These interest rates are tax-deductible
  • Some federal loans can be subsidized
  • Majority of student loans come with a variety of repayment plans

One key thing to do to avoid turning educational loans into bad debt is to make payments as soon as you are able to. The sooner you pay your debt, the less likely to increase the compounded interest you need to settle.

Debt has become a necessity for the majority of the lower to middle-income individuals and families wishing to fund their college education, but the reality is that not all degree programs are created equal. As a rule of thumb, you shouldn’t borrow an amount that is more than you expect to earn in your first year on the job.

For instance, if you think the average starting salary for a person with a master’s degree is around $65,000, then you should consider taking a lower loan amount than your expected salary.

This simple guideline can assure you that as your starting salary steadily increases over time, you will be able to keep paying the debt you have and will be able to pay it off within the usual 10-year repayment window. But keep in mind that if the economy you’re graduating into is a bit stable for your comfort, then you might want to reduce the debt you’d incur.

As impossible as it is to predict if an economy’s going into recession, people in college can’t also predict whether they can pay off the student loan they currently have while in school after they graduate. So, the best way to minimize financial turmoil is to minimize debt as soon as you can.

3.    Small Business Opportunities

Any debt incurred to start off a business, whether big or small, is a good debt. Starting or expanding your business is always a good financial investment for the future.

Capital will always be needed to start up or to expand any type of business. A good business model will be able to scale its operations and increase its profit over time. This would mean that a good business will generally have the capacity to pay off the loan used to set it up and generate profits long after the loan has been fully paid.

By this logic, business loans are considered to be “good” debt when it’s used to operate a business with the capacity to generate returns while paying off the loan.

Do note that in reality, this type of happy ending is not guaranteed in the real world. Setting up a business is a “high risk high reward” thing, and that sometimes business can fail to be profitable.

Investments in general have their own kinds of risks. Housing properties can decrease in value. The same can be said to bonds and stocks, an oversupply of degree holders may make it difficult to land a good paying job.

However, if the investment works just as expected, the risk will be all worth it. And that all debt incurred to take that investment risk can be considered as good debt overall.

Initiating a business means a lot of costs to consider. There are many things to consider before opening up shop like the following:

  • Equipment
  • Raw materials
  • Staffing
  • Commercial space
  • Marketing strategies
  • Accreditation and certification
  • Taxes
  • Office supplies

If you strategically plan your way through all the preliminary steps in starting a business, the debt incurred to start it will be repaid in no time. A start up requires a little bit of luck and a lot of elbow grease, but a good business can set you off into a life of financial success and comfort.

What makes debt “bad”?

Consider any debt that offers little to no chance of generating returns as bad debt. These are sunk costs as money used to repay these types of debt is generally considered to be lost forever.

A common example of bad debt in the modern world is credit card debt incurred buying electronic devices. As technology continues to improve over time, electronic gadgets tend to depreciate in value at a fast rate, offering little to no resale value.

We’re not discouraging you to shy away from these kinds of luxury items. However, it is best to incur debt when purchasing such things. Swiping your credit card for a designer bag otherwise you barely afford can put you in a number of financial stresses over time.

You might have a hard time paying off the credit card balance for the luxury item you just got. Or even worse, you won’t be able to use your credit card in case of an emergency because you haven’t paid off the balance. These kinds of financial circumstances are what you want to avoid at all costs.

Debt is a fundamental part of any business, and not all debt can easily be categorised into good or bad. It can depend whether the debt you have incurred can yield positive returns in the future.

Bad debt lowers your overall financial net worth. These are loans acquired to pay off things that lose value over time or do not aid in increasing your income. Generally, bad debts can be spotted a mile away due to the high interest rates they come with, making it a loan that’s quite difficult to fully pay off.

Sometimes bad debt can be attractive, but as a rule of thumb, any type of loan made that is unable to generate money is bad debt. To avoid these types of debt, be aware of the most common types of bad debt and consider whether it’s worth all the trouble getting them.

Bad debt examples

1.    Credit Card Debt

As stated in the example above, credit card debt is one of the most common forms of bad debt. Credit card companies allow you to conveniently purchase any item within your card’s credit limit. However, this type of convenience comes with a price, usually in the form of high interest rates.

But don’t throw your credit cards just yet. Owning one or two credit cards can still be a good thing for you if used wisely. One of the quickest ways to build up a good credit score is through the use of credit cards. By strategically using your credit card and paying off the balances as soon as possible, you’ll be getting credit scores that can make you eligible to get loans for big-ticket item purchases.

2.    Personal Loans

Similar to credit card loans, personal loans can quickly turn sour and put you into a lot of debt if you’re not cautious. However, not all personal loans are bad debts. It’s how you use it to your advantage that determines whether the personal loan you have is good or bad.

Interest rates of personal loans can range from as little as 5% to as much as 36% depending on your credit. But unlike credit card debt, personal loans usually are installment loans that you pay on a monthly basis for a certain period.

  • Personal loans can be used in a number of ways, such as:
  • Making an investment
  • Consolidating debt
  • Acquiring a big-ticket item
  • Financial emergencies
  • Travel

Considering the interest that is tied to personal loans, there are a number of scenarios where it can be considered as a good debt. For example, a person might not be qualified for a business loan, a personal loan can be used to start a business. Or if you have multiple debts under your name, you can consolidate it all with a personal debt to size it down into a single monthly payment schedule.

3.    Loan Sharks

As the name suggests, getting involved in any debt from loan shark lenders can spell disaster when seeking for financial assistance. You may know some of these lenders from your professional network that offer to lend money to borrowers without the need of thorough background check and extensive credit reports. Unlike other legit sources you can lend money from, loan shark lenders often set up loans that should be paid within a short period of time. Interest rates almost always tend to be higher than the legal standard.

In most instances, working with these types of lenders is against the law. That alone should be all the red flag you need, as the financial aid loan shark lenders bring may help you in the short term, paying them off can be just more stressful.

4.    Payday Loans

A more notorious type of bad debt is a common short-term loan from the working class called payday loans. These unsecured loans have gained their bad reputation from their over-the-top interest rates, some even running as high as 400%.

Combining the high interest rate with multiple service fees and penalties for late payments, payday loans heavily encourage its borrowers to pay off their loans as soon as possible. Missing your due dates by just a few days could mean doubling the amount you initially owed.

Much like loan shark deals, payday loans should be considered as a last report. If you’re strapped in for some cash, consider other options before getting into a payday loan.

5.    Car Loans

Many may say that car/ vehicle/ auto loans are a debt that is bad. It can also be argued that the moment you get a car, you are actually paying for a depreciating asset and that its value is going down much faster compared to any other assets like houses.

Buying a car may seem to be a good investment, but it actually all depends on what is the usage of it.

A more feasible way to compare could be to consider the convenience of owning a car that brings, with the transportation expenses. Owning a car may cost more (or slightly more) as compared to taking trains & buses and the occasional private hires or cab fares, but the convenience is way higher and the time saved, owning a car may be more feasible. For example parents with young children, they cannot even take private hires and can only get cabs. How about those that are giving care for the elderly in the family that has trouble transferring?

That being all said, generally speaking, auto loans are considered bad debt as a car’s net value typically depreciates over time, and it is important to know when to sell or trade in your car when you decide to own one.

Some of these factors affect how fast a car’s value depreciates:

  • Fuel economy
  • Service history
  • Mileage
  • Length of warranty
  • General changes in condition
  • Number of owners

The depreciation of a car can flush all the interest payments you’ve been making over the course of your auto loan down the tubes. That’s why when buying a car, it’s best practice to avoid spending more than what you need, and to reduce your loan’s interest rates by cashing up front as much as you can.

Conclusion

Being in debt is not as bad as society wants you to feel. Debt is normal, and that the right kind of debt can propel you to the financially secured future you’ve always dreamed of. And that any debt you currently have can either be bad or good, depending on how you utilize it.

At the end of the day, there is a solution for every debt-related problem you might be having.

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