Key tips on understanding good debt vs. bad debt
Not all debts are bad. Knowing the difference between good and bad debt is important in understanding how to utilize debt to your advantage. Some debts are good because they can augment your existing income or capital. These types of debts are in the form of:
- Business loan
- Education loan
- Home and a car loan
- Credit Cards
But debts become bad when you fail to pay them on time and in full.
Utang is a topic that is not discussed openly. It is also often a modest but imprudent excuse for most people when the conversation turns to money. “Hindi ako mayaman. Marami nga akong utang. (I’m not rich. I have lots of debt.)”
Most people generally think that all debts are bad, which results in a collective fear of having them. However, we need to take a closer look at the purpose of debt. While some debts do not add value to your lifestyle, there are other types of debt that may be used to extend your finances. Thus, knowing the purpose will help you differentiate good debt vs. bad debt.
These are some activities and facilities where you’re introduced to debt:
- Credit card: Credit cards are used to pay for purchases or services without having to carry around a large amount of cash.
- Business loan: Entrepreneurs need money to start businesses. Some choose to fund their fledgling companies out of their own pockets or through loans from friends and family. But as the business grows, more money is needed, hence loans. This type of loan is used to buy equipment and materials, to hire people, to pay for utilities, rentals, and other recurring expenses needed to keep the lights on.
- Education loan: Education is an investment, and children who get a proper education tend to grow into adults who do well at work and in life. Education loans let you earn your degree while deferring payment to a later time where you’ve gained employment and the ability to pay.
- Home loan: A home has the fundamental value as long-term shelter for your family. It is also an asset that can be sold or rented out for passive income.
- Car loan: A car’s value rests in the convenience and comfort in reaching your destination. Owning a vehicle can also provide more utility for your business.
See this related article: 5 rules on managing debts wisely
Bad debt
If you are unable to pay back borrowed money on time, then you have bad debt. This could harm your financial standing. Missing payments also results in overlapping increases in penalties, which further worsens debt.
What is the difference between good debt and bad debt?
Debt is considered bad if:
- It tempts you to spend beyond your budget.
- It starts taking from your savings or your emergency fund.
- You are unable to pay regularly and in full.
- You start borrowing more money to pay off other loans and have difficulty tracking how much debt you have built up.
- The terms of the debt or loan exceed the value or usability of what you bought with it (e.g. if you are able to use a car for only three years but your loan term is five years).
Good debts
Debts incurred through loans are considered good debt if you’re aware why you are getting one, and it doesn’t lead to financial ruin.
Examples of good debts are:
- Products or services paid to generate income beyond the debt or loan value (e.g. business loans)
- Debts that can be paid regularly, in full, and on time (e.g. credit card service)
- A loan that augments your ability to earn (e.g. education loan)
- A loan that allows you to upgrade your lifestyle (e.g home and car loans)
- A loan that helps build your financial discipline and long-term goals
How to focus on good vs. bad debt
Shifting from having bad debt to good debt takes time and involves major changes in financial mindset.
It starts by making wise decisions about your future . This means thinking about the benefits of what you’re getting when you’re taking on debt. For example, taking on a student loan to complete your postgraduate degree to help you get a high-paying job is a good form of debt because it is an investment in yourself that pays off in the future.
If you do happen to find that you have incurred quite a lot of bad debt, you need to develop a strong debt management strategy to clear it as soon as you can. You can read more here about how to manage debt wisely.
For most people, having no debt is close to impossible. So instead of beating yourself up about incurring debt, focus on choosing and managing your debts wisely. Get into the habit of building good debt with a Metrobank credit card. When you’re ready, consider getting a car loan or home loan with Metrobank.
This article is part of a collection of stories and practical financial tips that are published with the goal to help people learn from the experiences of others, and to pick out lessons on personal finance and sound money habits beyond the pandemic.
