The idea of debt can seem stressful and scary. And in many cases borrowing money isn’t the most sensible thing to do. But there are also times when it does make sense to get into debt.
So, how do you work out if borrowing money is the right thing for you? Thinking about ‘good’ and ‘bad’ debt is a useful way to decide whether borrowing is really your best option.
What is ‘good’ debt?
Good debt helps you manage or improve your money
Good debt should leave you better off in the long run. You can use it to build wealth, save money and make life a little easier. Here are some examples of when it might make sense to go into debt:
Spreading costs. It isn’t always realistic to use your savings for large or unexpected costs. So credit can be a convenient way to pay these costs over time.
Say you need a new car for your work, but you haven’t saved up enough to buy one outright. So you buy an affordable car using a loan, which you repay over a set period of time. You have to pay interest, so the car does cost more. But you’re better off because the loan makes it possible for you to earn a living.
Debt can sometimes even help you save money. Say you travel to work by train. It costs £7,000 for a year’s worth of day tickets or £5,600 for an annual season ticket. You use a loan to buy the season ticket and pay it off over the year. You pay £350 in interest. By going into debt, you’ll have saved a total of £1,050.
Making a sensible investment. This could include:
- Taking out a mortgage to buy property that increases in value over the years
- Getting a student loan to pay for education that will increase your earning potential
- Taking out a business loan to start or grow a profitable company
Building your credit score. Managing a credit account responsibly can improve your credit score. A good credit score makes it easier to get accepted for better credit deals, meaning you can borrow money at cheaper rates. Just remember that taking out credit will lower your credit score temporarily. It should recover and improve over time, as long as you stay well below your credit limit and meet the repayments on time and in full.
Good debt is affordable
Good debt doesn’t damage your overall financial position. The repayments shouldn’t eat into money you need for rent, bills and other essentials. And it shouldn’t get in the way of important financial goals, such as saving for a house deposit or contributing to your pension.
You need to be sure you can meet the repayments for as long as you have the debt. It’s usually best to pay off debt as quickly as possible, to minimise its cost and impact.
You can get an idea of how much you can afford to repay by looking at your household budget. If you have a Monzo account, you can use Summary to see how much of your income is already committed to things like bills.
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Good debt suits your needs
There are many different ways to borrow, including credit cards, loans and overdrafts. If you want to take out good debt, the type of credit must suit your needs and financial abilities.
This means you need to do your research. Compare offers to find the right type, terms and charges for you. Remember that interest rates don’t always tell you the true cost of credit – you should also think about things like penalty fees, Annual Percentage Rate (APR) and how the interest is calculated.
What is ‘bad’ debt?
Bad debt doesn’t pay for itself
Bad debt drains your wealth and leaves you worse off. This often happens if you use debt for an impulse buy or a luxury item – especially something that loses value quickly. For example, the average car loses 60% of its value in the first three years. If you need the car to earn a living, then a loan may be sensible. But if you don’t need the car – or you buy a more expensive car than you need to – then debt is usually a bad idea.
Bad debt wastes your money
Expensive debt is often bad debt, even if you can afford to make the repayments. If you haven’t looked for the best deal, you may be throwing money down the drain – money you could be using to buy nice things, reach your savings goals or invest.
Bad debt is unaffordable
Bad debt can force you to live on a shoestring budget, which isn’t good for financial security or your wellbeing. And being unable to repay debt can lead to serious problems such as:
More debt. Compound interest can make your debt grow by itself – and the longer you’re in debt, the faster it will grow. If you miss minimum repayments you may be charged penalty fines, which can also add to your debt. Finally, bad debt can use up money you need for bills, which can put you in debt with other companies.
A defaulted account. This means the lender closes your account and can take legal action to get their money back. They may take your home or car if your debt is secured against these possessions.
A lower credit score. Missing payments or defaulting on your account can damage your credit score. This can make it harder to get accepted for credit in the future – even for things like mobile phone contracts and energy tariffs.
6 questions to ask yourself before getting into debt
Ask yourself the following questions before taking out debt. If you answer ‘no’ to any of them, it’s probably not a good idea to get into debt:
- Have you compared credit to find the best offer for you?
- Are you sure you can comfortably meet the repayments?
- Is there a chance your interest rate could rise? If so, could you still meet the repayments?
- Do you understand the risks involved? And are you willing and able to accept them?
- Do you have a clear, specific reason for borrowing money?
- Will borrowing the money improve your financial situation in the long run?
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