As of April 2018, the average debt of an adult in the UK was £30,601. Debt is a difficult animal to understand. On the one hand, we’re told that to be in debt borrows from your future income, encourages you to buy a life you cannot afford, and can lead into a downward spiral of ever increasing interest rates. On the other hand, without debt many of us wouldn’t be able to buy our own home or secure a tertiary education.
This is because not all debt is created equal.
There is a clear and important difference between ‘good’ and ‘bad’ debt, and it is one worth learning before you take on any new debt in your life. Take a look below to figure out the type of debt you are currently carrying.
Broadly speaking, good debt is debt with low interest, debt that increases your net worth, or debt that helps you purchase something that increases in value over time. Two examples of good debt are:
1. Housing and property
To buy a house most of us need to take out a mortgage. A mortgage is an example of good debt because it is low interest. Additionally, although the loan amount is large, it is offset against the fact that houses are generally expected to increase in value over time. It also usually only requires a small percentage of your income in order to repay it, meaning that you still have funds with which to invest in other ventures or spend on daily life. Because you are actually investing something that increases in value, this is ‘good’ debt.
2. Student loan
Again, student loan debt is good debt because it has very low interest rates, especially compared to private or other banking loans. Furthermore, there is a strong correlation between those who finish tertiary education and those who earn higher salaries. By investing in your education and taking out a loan, you are actually increasing your net worth in the long run. This is what makes your student loan a ‘good’ debt.
Conversely, ‘bad’ debt is debt that has high interest rates, doesn’t add anything to your net worth, and is incurred buying a product whose value only decreases after purchase. Examples of bad debt are:
1. Credit card
Although an everyday part of our lives for many of us, credit cards are actually seen as ‘bad’ debt. Interest rates on credit cards are high, with the average APR being 17.9% (and that’s if you have a good credit history). Furthermore the debt you pay on your credit card does not generate any extra income or increase your net worth.
2. High street store cards/pay day loans
In the same vein as credit cards, high street stores cards have incredibly high interest rates and the minimum payment arrangement encourages the consumer to keep an outstanding balance on their card, therefore spending more money in the long run paying off their debt. Additionally, high street store cards, by their very nature, are designed for you to buy things that depreciate in value rapidly, such as shoes and clothes.
Pay day loans are also notorious for having astronomical interest rates. In fact the British Government had to introduce legislation in 2015 in order to cap the amount of interest that could be charged on a pay day loan. They do not add value to your net worth or increase your earning potential. They’re therefore, ‘bad’ debt.