While many draw negative connotations from the term ‘debt’, it’s not always a terrible thing. While ‘bad’ debt definitely exists, so too does ‘good’ debt. It’s important to be able to differentiate between both types of debt to understand what applies to your situation and what changes need to be made if you’re struggling.
What is ‘good’ debt?
While you’ve probably been told that all debt is bad debt, this definitely isn’t the case. A lot of debt can be beneficial to your financial future if utilised in the right way. As a rule of thumb, good debt can be described as debt that increases your net worth, or helps you purchase wealth-building assets. Appreciating assets are therefore classified as good debt, as they can be considered a long-term investment.
For example, taking out student loans will likely increase your future earning potential, and make it easier to find stable employment. Popular examples of good debt can include:
- Home equity (renovations that don’t cause over-capitalisation);
- Investment loans for business owners;
- Student loans (HECS-HELP loans in Australia).
For most people, it’s unrealistic to go through life without taking on good debt. However, always keep in mind that good debt has the potential to turn bad if it’s not handled properly.
What is ‘bad’ debt?
In a nutshell, bad debt is something that you want to avoid accruing too much of. This type of debt doesn’t help you financially, and can end up costing you a good sum of money in interest charges and additional fees. Unfortunately, though, bad debt can be easy to accumulate and difficult to get on top of. Some examples of bad debt include:
- Payday loans;
- Credit card debt;
- Personal loans (for discretionary items).
Sometimes bad debt is unavoidable. You may need a new car, and have no choice but to take out a car loan to cover the expenses. In this situation, accruing ‘bad’ debt allows you to purchase a car and pay it off over an agreed-upon timeframe.
On the other hand, though, taking out a personal loan to cover discretionary items like clothing and electronics isn’t always the best option. As these items are depreciating, they offer no financial benefits in the long run.
What happens when debt gets uncontrollable?
Unfortunately, excessive debt is a serious yet common problem. When someone is in extreme financial hardship, their last option is usually to declare bankruptcy. Doing so means that you’re legally admitting you’re unable to pay your debts. This can be done voluntarily, or forced by a creditor through a court process called a ‘sequestration order’.
Declaring bankruptcy will cover most unsecured debts, but incurs many consequences. Most notably, bankruptcy will be recorded on your credit report for five years, or for two years from when your bankruptcy ends (whichever comes first).
When someone declares bankruptcy, it usually is a result of:
- Loss of job and/or income;
- Relationship break-up/divorce.
In order to declare voluntary bankruptcy, you need to complete and submit a Bankruptcy Form through the Australian Financial Security Authority. You will then be assigned a Trustee, who will manage your bankruptcy and overall finances.
- Seek financial help, from a financial advisor or institution;
- Understand your options, including taking out a Personal Insolvency Agreement (PIA) or another form of debt agreement;
- Understand the consequences of declaring bankruptcy.
Considerations about ‘good’ and ‘bad’ debt
In some cases, classifying debt as either ‘good’ or ‘bad’ isn’t as easy as you might think. The way debt is perceived relies on a person’s financial position. A common reason for taking out ‘bad’ debt is to consolidate your debt i.e. to borrow money to pay off existing debts. While taking out ‘more’ debt may seem illogical, it might be the best financial option in this situation. Choosing to cover your existing debt with a credit card will most likely result in high interest charges, whereas consolidation loans tend to have lower interest rates.
How to avoid ‘bad’ debt
In short, it’s much easier to avoid bad debt altogether, rather than try to pay it off at a later date. While you may have good intentions, bad debt can easily spiral out of control and become overwhelming. While it’s not always possible to avoid bad debt, there are ways to minimise it.
The number one way to avoid bad debt is to avoid payday loans altogether. If you’re needing some cash and savings won’t cut it, a personal loan can be a good option. Payday loans, however, incur huge interest fees and more than likely will create a cycle of debt.
Another way to avoid bad debt is to avoid high-interest credit cards. If you do use a credit card, consider the attached rate of interest and shop around to see if you can get a better deal. Also, if it’s financially viable, try paying off your credit card minimums before they’re due to avoid paying interest.
If you’re struggling to find a lender that will approve your bad credit application, give Jacaranda Finance a shout and chat to one of our friendly customer service representatives today.