When not all debt is bad, what then is good debt and how do you tell them apart?

Being in debt isn’t as bad as some may think. You see, not all debt is necessarily bad. At the same time, not all debt is good either.

So which is it – good or bad?

We delve into what is debt and makes good debt good versus what makes bad debt bad.

What is Debt and Why So Serious?

Debt is a sum of money owed. If you’ve borrowed money from someone or from an institution (banks, PTPTN), and the money has to be paid back, that is your debt.

A debtor is the person who has borrowed money, therefore incurring debt. A creditor is the person lending the money.

Interest is particular rate charged to you at a regular interval for the money you have borrowed and have not paid back. After all, if the creditor had not lent you the money for a duration of time and had instead invested it, the creditor could have potentially earned a tidy sum through compounding and inflation.

As even children learn, when you borrow money, you must honor the promise to return the money owed by the agreed upon deadline. As an adult, the basic principle is the same. Honor the terms of your agreement or face the consequences.

These consequences vary depending on terms written in your agreement. And these consequences can indeed get bad. For example, even the simplest consequence is to charge you higher interest, eventually growing larger and larger, compromising your financial situation and even driving some to commit suicide to escape the pressure of mounting debt, leaving their family bereft. What’s worse is the family can inherit the debt (!) and now have a duty to pay back creditors on the deceased’s behalf. What a horrible legacy to leave.

It is no surprise then that many a cautious parent or grandparent will caution their family members from incurring debt.

So, why are we saying there is such a thing as good debt?

Things to Consider Before Categorizing Your Debt

Before you can categorize debt as good or bad, you need to understand more about why and what you are or were getting into.

Firstly, we look at the intention. Do you have a clear and realistic need to incur debt?

  • Why do you need this money for?
  • How did you end up needing money for this?
  • Is there long-term value in using money for this “need”?

Secondly, we look at the situation. Do you have a realistic plan to pay off your creditors?

  • How many debts are you currently already servicing?
  • Are you able to service your debts in a timely manner?
  • How healthy is your current DTI (debt-to-income ratio)?

Debt-to-Income Ratio (DTI) = All your monthly debt / Monthly income after tax and EPF deductions
DTI should be below 35% including property mortgage or below 20% if without.

Thirdly, we look at the terms. Have you shopped around for the best options? Consider the amount, duration, interest rate, and penalties.

Consider all these three aspects as you look at each debt you have. Moving on, we will use your answers to these three aspects to categorize your debt.

What is Good Debt?

There is an old adage that says “it takes money to make money”. It is very true indeed that wisely-spent money opens doors and windows for many opportunities while sheltering you from pitfalls.

Good debt is debt that brings positive financial value to your life while meeting your needs. It is debt that helps you increase your income, your net worth, or your overall financial health either immediately or in the near future.

To begin with, let’s look at your intention. Here are some examples that lead to good debt.

  • I need the money for my university education in order to get better paying job.
  • I have a very sound business plan and I need money to start up my business based on that plan.
  • Upon advise from a licensed financial planner, I am incurring lower-interest debt to pay off my high-interest debt.
  • I am taking a low-interest long-term property loan to finance my home purchase, while investing my own cash in hand and harnessing the power of compounding, eventually resulting in higher net worth as the gains of my investments will far exceed the interest charges incurred from the property loan.

Good debt also happens when your situation is good (DIR above 35%) and the terms are affordable, agreeable, reasonable to match your current situation, and have penalties are not dire.

Good debt is a balance of positivity from all three aspects of intention, situation, and terms. While borrowing money now may not make you feel wealthy, when all three are positive then you can look forward to the promise of a wealthier tomorrow.

What is Bad Debt?

Bad debt is any debt that drains your wealth, is unaffordable, and generally isn’t going to “pay for itself” in the long run. It doesn’t increase your net worth and does not bring positive financial value.

If your intention is to incur debt in order to spend on something that is perishable/consumable (clothes, expensive meals, new TV) or on unnecessary wants (upsize your basic wedding budget, luxury holiday, extra car), you should stop right there. These are items that do not “pay for themselves” and bring no positive financial value in the long run. If you cannot afford to pay for them using cash from your regular budget, then you should not be attempting to buy them.

Bad debt also occurs when your situation is not financially healthy. While your intention may be positive, if your debt to income ratio is in a bad state, you are only making things worse by adding on debt. The debt to income ratio is a tool that indicates one part of your financial health. If you find that your situation is not good, do seriously consider engaging a licensed financial planner to sort out your existing debt first.

Another bad debt red flag to avoid is when the terms are not good. For example, the interest rate is not attractive, you know you most likely wont be able to pay off within the time period given, the compounding interest for late/no payment is staggering.

Conclusion

When we incur debt, we’re actually borrowing from our future selves. By ensuring we have the right intention, situation, and terms, we can make conscious choices to incur good debt that brings us to a positive financial state in the future.

If you are having issues with bad debt, signup for a MyPF membership and get connected to a licensed financial planner for professional help.

 

You May Also Like