WHAT IS BAD DEBT?
Many people consider any type of debt to be a bad thing but it is almost always necessary. If you want to own a house you’ll probably need a mortgage – it’s highly unlikely you’d be able to pay the full price up front – but mortgages are counted as debt like any other loans.
This is why you need to understand what can be considered ‘bad debt’ – as well as the reasons for avoiding it if you can.
What is bad debt?
It is essentially a debt that cannot be repaid in time or in full and that will negatively impact your financial situation. Bad debt is debt that is not affordable, drains your disposable income and puts your financial future in trouble.
Debt is usually classed as bad when people take it on without a proper repayment plan in place, living day to day without really thinking about how they’re going to clear it eventually.
However, a credit product can also quickly turn into bad debt if your situation changes and you start to struggle making repayments. If you lose your job, for example, you may find that a basic credit card becomes a bad debt that you are unable to repay.
This means if you do not find a solution, you may find yourself with late payments marked against you on your credit report and even legal issues later down the line, as defaults or judgements are listed against your name.
This is why it’s so important to look into ways of providing yourself with a savings buffer, once you have cleared your debts and are not making any big repayments.
Credit products that have a higher chance of becoming bad debt:
A loan for a new car that isn’t a necessary purchase – Whilst we all enjoy having nice new things, it’s important you think carefully before making big purchases and using credit to obtain them. A personal loan may seem like a good option but if the car isn’t a necessary purchase, it’s a debt you don’t need that could impact your financial situation.
A payday loan – While the Government has been seen to be tackling payday loans recently, the interest rates are still very high and, if you don’t have enough money in your account once that first payday rolls around, that loan you took out as a quick fix for your money issues may just stick around much longer.
Borrowing to pay your bills – If you need to borrow money to pay bills or even other debts, you may find yourself in deeper trouble later.
A loan for a holiday you can’t afford – Many people have been known to take out personal loans or put everything on a credit card when it comes to paying for a trip abroad, but this can quickly lead to bad debt later down the line. While you might have an incredible time away, you’ll return home to stressful financial trouble if you have no way of paying these debts off. Instead, save up for that big trip and take time to plan your finances for it carefully.
A high interest credit card – Many cards draw us in with enticing offers of 0% interest over a period of time but, if you accumulate a large amount of debt and don’t pay this off once the welcome period is over you could end up with bad debt. This will more than likely be due to the fees and interest charging so much, you find it difficult to make repayments and start to fall behind.
Credit products considered to be good debt:
Good debt offers opportunity. It allows you to improve your situation and it is, of course, a debt that you can afford to repay. Here’s a look at what could be considered good debt:
The mortgage for your home – Without a mortgage, most people would not be able to own a home. It’s a standard procedure for many looking to purchase property and if you make repayments in full and on time you will also improve your credit rating.
A student loan for university – Going to university improves your chances of landing a good job and earning a decent wage and so the debt associated with it is a good one. It can help to ensure that you are able to repay debts in the future and benefits you financially. Plus, it is not listed on your credit report and the amount is automatically taken from your wages based on what you earn – so you are unable to fall behind on repayments.
A loan you can afford for something you need – Debt should only be taken on if necessary and if you’ve done your research and budgeting beforehand. It is not something to take lightly. So, if you do need a new car and have budgeted for a loan that you can comfortably repay that is an example of good debt, as a good track history of on time repayments improves your credit rating and history.
How to avoid bad debt
Bad debt can be avoided, it’s simply a case of being careful when it comes to where to borrow money from and how much you take on. Here are some questions to ask yourself before taking on any level of debt, to avoid bad debt in the future:
Would I be able to cope if the interest rate increased?
Interest rates can easily catch out even the most careful of borrowers so it’s important to take some time to consider your personal situation and whether the debt you are taking on could put you at risk if the rate went up.
Have I got the best deal?
It’s important you ‘shop around’ and compare credit products before taking one on. Many offer great initial rates, then add huge increases later. Sometimes it may be best to opt for a product that stays at the same guaranteed rate.
Can I make repayments comfortably?
Check your current income and expenses to see what you have left over that is disposable. This is what you would have left to put towards a new debt repayment. If it makes your money situation too tight then it’s best to avoid it
Have I read all of the small print and understood the terms and conditions?
It’s so important you carefully check over a credit product before taking on the debt. You don’t want a nasty surprise in the form of a fee or higher interest rate later that turns it into a bad debt.
Am I borrowing more than I need?
It’s a good idea to only borrow exactly what you need and can afford. If you borrow more you’ll be tempted to spend it all and put yourself at risk of not being able to pay it back.
Do I have a savings buffer?
Having a small amount of spare cash in a savings account can get you out of a sticky situation if your circumstances change later while repaying a debt.
If you need help with any debts that you may have, that you are struggling to repay, then get in touch with our expert team at Debt Savvy on 1300 912 197 or fill out our free assessment here. One of our team will go through your options, help you get back on track and decide on a solution to fix your debt.