Good Debt vs Bad Debt: Unpacking The Difference
Taking on new debt isn’t always a bad thing. Some types of debt can help you reach your financial goals, build your asset portfolio, enhance your life and increase your wealth over time. However, other types of debt can have you kissing all of your financial goals goodbye.
The kind of debt and how much you take on determines whether your financial deficit is good or bad. Most businesses are paying a debt of some sort. Whether it’s a mortgage, business loans, or credit cards, debt is a standard part of modern life.
While there is a clear distinction between good debt and bad debt, it’s ultimately how you manage debt that counts. Today we’ll break down the different types of debt to help you find the right balance between the good and the bad.
What is good debt?
Good debt is money borrowed for items that appreciate over time. Taking on good debt can help you become asset rich or qualified in a well-paid profession.
As the saying goes, “you’ve got to spend money to make money”. Good debt is an investment in your business’s financial future but needs to be well-managed to avoid spiralling out of control. Like all debt, good debt incurs interest, and you need to be in a position to make repayments comfortably.
Let’s look at the most common types of good business debt:
Starting a business
Creating your own company is a courageous move. Lucrative business ideas should be pursued, and a business loan helps you get established. As your business expands, your debt will shrink. However, the same can be said in reverse. Businesses must be successful in order to repay business loans.
With a combination of ambition and sheer luck, businesses can thrive from the get-go. If this sounds like you, borrowing money to start your own company could be the best financial decision you ever make.
Taking out a mortgage for business premises
A mortgage is arguably the most common type of good debt.
Taking out a mortgage for your business premises is a huge commitment, and you need to prove that you have the means to repay it with interest. The rule of thumb is to limit your mortgage repayments to 36% of your total income and consider interest rate fluctuations over the duration of your loan.
As repayment periods may last up to 30 years, mortgages are a long-term obligation.
Education and training
Earning a qualification could be your ticket to building a career as a successful business owner. Taking out debt for higher education is an investment in your future and sets you on the path you envisaged for yourself. Most importantly, the more qualified you are, the more earning potential you have.
To become qualified in a chosen field, student debt is par for the course. However, it’s important to cap your debt at 10% of your projected earnings. When you enter the workforce, you’ll be required to pay off your student debt, so be sure to keep tabs on how much you’re taking out.
What is bad debt?
Bad debt doesn’t always feel ‘bad’ at first.
It’s not until the repayments kick in that you realize what you’ve got yourself into.
Borrowing money for something that depreciates in value is considered bad debt. That’s not to say taking out debt to purchase some large items is always a bad thing. Debt is a common factor in running a business.
Again, it’s how you manage debt that counts.
The thing is, money is easy to spend and difficult to save. It’s even harder to save when you’re losing a good chunk of your paycheck to debt repayments. There may be times in your business’s life cycle when incurring bad debt is necessary, but you need to avoid becoming overwhelmed by it.
Once you’re in the depths of a debt trap, it’s tough to find your way out.
Let’s look at the most common types of bad debt.
Company car finance
Cars are an essential item for you and your employees, especially if you’re required to work off-site or meet with clients. But they come with a large price tag. The more reliable your car, the more it will cost. And we all want to avoid purchasing a car that requires ongoing maintenance.
So, financing your company vehicles is the only option for many business owners.
Cars depreciate in value from the moment they’re driven off the shop floor. This is why car finance is considered bad business debt. However, in most cases, it’s necessary bad debt.
As long as you set your sights on a reliable, modest vehicle, car finance can be very manageable. Just keep away from leasing a Ferrari for business use.
Company credit cards
Swiping the credit card for every business expense is easy and convenient. As long as you have a plan to pay off the balance every month, there’s no issue doing this.
Things can quickly get out of hand when multiple employees have access to the company credit card with no regulation. Before you know it, your expenses have skyrocketed, and your credit card balance has dipped well into the red.
It’s not uncommon for the company credit card to take a huge hit every month. Hence, credit cards are considered bad business debt.
Credit card interest stings, especially when you can’t pay your balance off in full every month. With interest added, the items you purchased may end up costing you a lot more than what you originally paid.
The problem with credit cards is that business owners use them when they don’t have enough cash flow to make a large purchase. If you don’t have the cash in the first place, it’s unlikely you’ll magic up the cash by the end of the month.
To avoid becoming overwhelmed with credit card debt, set tight regulations and monitor employee expenditure closely.
Personal loans help you obtain the things you need at a lower interest rate than credit cards. If you’re starting a business or consolidating debt, personal loans are a great financing option.
But personal loans are just that: a loan. Taking out a personal loan to use as discretionary business cash flow is never a wise choice. Spending loan money like it’s your money is a fast track to unmanageable business debt.
Like all debt, personal loans incur interest and come with the expectation that they will be paid back over a predetermined period. Before taking out a personal loan, be sure of what you can afford in repayments.
Debt has become a common part of our everyday lives. A life without debt could mean a life starting a business or having the convenience of a company car. Sometimes debt is necessary, but taking on only what you can afford to pay back is the best way to ensure your debt doesn’t destroy your business plans.