Good debt vs bad debt: why not all debts are equal, and how to know the difference

Mouthy blogger Tolu Frimpong looks at the concepts of good debt vs bad debt, and which you should tackle first.

There are two different types of debt, often referred to as ‘good’ debt and ‘bad’ debt.

While all debt should be avoided or paid as quickly as possible, not all of it requires paying immediately.

We will explore both types of debt in detail, and we’ll also be exploring some of the dangers associated with accepting the notion of good debt.

What is bad debt?

Bad debt, also known as consumer credit, takes money out of your creditors’ (i.e. banks or credit card companies) pockets and is spent on things that do not bring a financial return.

Some people often use bad debt to fund their lifestyles, spending more than they can financially afford on clothes, shoes, holidays, nights out, entertainment and so on.

Once a person spends the credit, it’s gone, has no chance of bringing a financial return, and must be paid back, usually with high interest rates.

In the long run, that trade-off isn’t worthwhile.

I’ve spoken to many people who have paid back thousands of pounds worth of this kind of debt (I was one of them), and you always regret wasting so much money.

Avoid the trap! Just read the debt stories I shared on International Women’s Day from three women who have paid off large amounts of unnecessary consumer debt, and you’ll see what I mean.

These five practical ways to beat debt will help you if you currently have bad debt that you want to pay off.

What is good debt?

Good debt is debt used to generate an income or wealth and potentially to make even more money. The more appropriate or relatively common term for good debt is leverage.

Leverage is the act of borrowing funds to expand or invest. The goal here is to use the loan to generate more value than would have been possible without it.

The person taking on this debt planned and budgeted for and measured the risk vs reward of the debt. Good debt is usually well-considered and thought through.

Good debt includes buying properties (mortgages), taking a loan to start a business, paying for education with a student loan, and credit building debt.

Is good debt really good?

The definition of bad debt is quite universal, and most will agree on what constitutes bad debt.

On the other hand, good debt can be quite a controversial one to debate. Let’s explore some of the issues with good debt, and when it can turn bad.

1) Beware of Ponzi or pyramid schemes

Have you ever been presented with a business proposition that seems too good to be true? A “small” investment of just £5,000 in a training program or overly expensive product, and you’ll be making £50,000 a month within the next three months.

Sadly, many people who fall for these scams are convinced to take on good debt for the promise of substantial quick returns.

2. Plans fail

You can plan diligently, do all the risk assessments possible when embarking on a new business venture. However, there are many success factors beyond your control.

Take the global pandemic that we’re currently living through: no business owner would have foreseen this coming and its effect on their business. Many businesses sadly failed. That good debt they started with is now bad debt.

3. There are no guarantees

As mentioned earlier, student loans are considered good debt. Students get degrees to secure good jobs after graduation. However, there are no guarantees.

They may not get that dream role and have to work in a field paying considerably less than anticipated. Also, according to the Office of National Statistics, one in eight young people without degree-level qualifications are working in graduate jobs.

The same goes for buying property. While you pay off the mortgage over time and house prices tend to rise, this is not guaranteed. It can also become a problem if you lose your ability to repay your mortgage, through illness or unemployment. This makes insurance protection with life, serious illness or income protection an important consideration.

While it’s clear that there is such a thing as good debt, it’s also clear that it can quickly turn into bad debt.

Ultimately it’s essential to understand your risk when acquiring debt. Whilst leverage can be a force for good, what will you do when things don’t go according to plan?