Good Debt versus Bad Debt: Understand the type of debt you have to see if your credit is working for or against you.
If someone asked you ‘Are you in debt?’ – apart from possibly being slightly put out by the personal nature of the question – how you answer will probably depend on how you view the word ‘debt’. Strictly speaking, a debt is something (usually money) that has to be repaid to the person/organisation that loaned it to you in the first place, normally with some additional cost for the privilege. By this definition anyone who uses an overdraft on their bank account, has a mortgage or who owes their mate £20 because they forgot to take any cash to the pub last Friday has debt.
So that’s nearly all of us then. But is being ‘in debt’ different to having a mortgage? Do you think of debt as being worrying whilst others think it is perfectly acceptable? Does the term being ‘in debt’ imply that owing the money is causing you problems? Is there a way to make credit work for you rather than against you? Read on…Credit that works for you…
In this day and age, it is almost impossible to live debt-free. Let’s be honest, most of us can’t pay cash for our homes or our university education. So if you want to achieve these things, it is likely that credit can help you. Debts, such as a student loan or a mortgage, which help you achieve a very specific positive aim, are normally the best kind of credit. Generally they have lower interest rates than other debt. And they can actually help you accumulate money in the longer term, by taking advantage of rising property prices or by securing you a higher paid job when you graduate.
A ‘car loan’ might also be considered as a good use of credit, especially when the vehicle is essential to getting to work or doing business. However, remember that unlike homes, cars and trucks normally lose value over time.
Used wisely, this sort of credit, paid back over a long-term with relatively low monthly payments, will allow you to achieve your specific aspiration whilst enabling you to keep the rest of your money free for the other things in life; investments, emergencies or simply enjoying yourself. The key of course, is everything in moderation – even a mortgage can become a nightmare if you can’t afford the repayments. So don’t overstretch yourself and make sure you will continue to be able to make the payments, if interest rates rise or your income falls.
Equally, in certain emergency situations, credit is the sensible option. If your washing machine broke, buying a new one on credit may actually work out cheaper than using a laundrette for the next six months, until you have saved for a new one. But again, make sure you have a plan for the repayments and can afford them.
Some credit, particularly credit cards, may also come with a 0% interest rate, which means you only pay back what you borrowed. These deals are often for a limited period of time and revert back to a higher rate once the introductory period has finished. If you know you will pay the bill off within the introductory period, it’s a win win and once the 0% interest rate has finished, remember to switch to a new provider so that you don’t incur additional interest. Remember if you fail to keep up with the repayments, you may be considered to be a risk and the lender can increase the interest rate at any time. So make sure you always read the terms and conditions before you sign on that dotted line.
Credit that works against you…
There is no particular type of credit that is instantly a no-go. Depending on your circumstances and your options, credit could be the right choice, particularly in emergencies. However, credit starts to work less in your favour when it is used to pay for things that you could do without and can’t really afford (that holiday to Thailand, for instance!). Or when used to purchase things that quickly lose their value and/or do not generate long-term income.
There is nothing wrong in buying something simply because you want it, but make sure you can afford it, and won’t be paying it off long after it’s gone out of fashion.
Shorter term credit works best if you use it, as the name suggests, only in the short term! This sort of credit is more likely to carry a higher rate of interest, particularly if you borrow for a longer period. This means that if you pay it off straightaway, you may benefit from no or lower interest. But if you delay – only paying the minimum payments on a credit card for example – then you will be paying the debt off for months if not years and will probably have paid for the item twice over.
To sum up, make sure that you are using credit to create positive outcomes for you and your family – not to put cash in the lender’s back pocket rather than your own!