What is Debt?

If you would like a simple answer for, what is debt. here is mine:
‘Debt is borrowing money to buy something that you cannot afford at this point in time.’

Simply there are two types of debt: good debt and bad debt. Both have their place in your personal finance and both need to be managed correctly. Let’s look at each type of debt a little closer.

What is Bad Debt?

Borrowing money to buy something that depreciates in value.
Bad debt is your car loan, the $50 your mate lent you at the pub, or the credit card you have run up with the overseas holiday you always wanted. Too put it simply we can say, bad debt is money you owe to someone for something that has no lasting value.

There are times in life when using bad debt is beneficial. A car loan. You have just finished your higher education. Now have landed that dream job, however you are in need of a car to get to and from work.  You have been working part-time when you were studying, though the few hundred dollars a week you earn was spent on living week to week. I could see the understanding for a car loan at this point in life.

The important points are:
  • Details of the loan
  • Ability to make payments
  • Effect on future lifestyle


A personal loan can vary in time frame, however let’s say five years. Do you know have a five year plan? If so, what happens if things change?


Look at these Numbers:

So you have found a good car for $14000. The bank will let you the money at 14% over 5 years. Now monthly payment are $325 and the total amount paid back will be $19545.

Firstly, how will the monthly payments affect your new budget? Then, how will these payments affect your future lifestyle over a five year plan?


And after five years, your $14000 car is worth maybe $9000. You have ended up paying $19545 plus insurance, registration, servicing, petrol… Costs, let’s say $4000 a year, so $20000. So the dream job you have landed paid you over $250000 for the 5 years period, and you have spent $40000 on travel to and from home.

Were the details of the loan right for you?
Could you budget for the payments and costs?
And how did it affect your lifestyle?
 

What is Good Debt?

Borrowing money to buy something that appreciates in value.
Good debt is the loan for your investment unit, business start-up costs, or higher education costs. We could say, good debt is money you owe for acquiring assets.

Is the family home Good Debt? Find out more here

To be able to create wealth, not save wealth, good debt will be one of your tools. The concept is borrowing money which will create a debt, this is your liability. To purchase an item which creates an income, this is your asset. Now the item’s income need to exceed the cost of the debt, and the amount it exceeds is your profit. Profit from your asset is what makes the debt a good debt. If this asset does not make a profit and costs you money, then you have bought an asset with bad debt. Using bad debt to buy an asset can be done if it fits into your budget and plan however it is a much slower and harder way to create wealth.   

Once again the important points are:
  • Details of the loan
  • Ability to make payments
  • Effect on future lifestyle


The different will be there are going to many more details to understand, as there will be details of the loan, asset and making sure they work together insuring the debt is good debt and not falling into bad debt. On the other hand, If the details are right then ability to make payment should be covered and the effect on future lifestyle should be positive.

A.W.

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