Bad debt vs good debt

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Bad debt vs good debt

As soon as you leave university or college and open your first professional bank account, you unknowingly send an open invitation for lending institutions such as banks and stores to offer you credit. The sad reality is that for most people, this becomes the first major financial decision they make rather than one on investments. If you use your credit facilities for consumptive purposes, such as to buy clothes, food, fuel, take out, appliances or furniture, this is what I would classify as bad debt. If you need to use credit to finance your lifestyle that is a big red flag that you are probably living beyond your means and a sign that you need to scale back.

Sadly, living off your credit card is like having cocaine. While you might have started with a limit of R5 000, over time, you want bigger better things and as such need a higher limit to sustain those purchases and these require higher credit limits. Those that have taken cocaine mention that with each dose, you increasingly want more to get the same level of satisfaction or the same high! With a higher credit limit, you will be required to pay a higher monthly repayment and before you know it your debt to income ratio becomes unbearable and all you do from month to month is pay off those credit accounts. Your debt to income ratio is a measure of the total value of your debts in comparison to your monthly income. In an ideal world, you would want this ratio to be about 0.3:1 or less to allow you to allocate your monthly income to other important things like investments and savings. As an example, if you pay R5 000 every month for your credit card, Zara clothing account, personal loan and fuel card while you earn R12 000, this means that your debt to income ratio is 0.42:1 and that is a problem that you need to start fixing.

Contrary to bad debt is good debt and this is debt that one would take to finance the purchase of an asset or to buy access to future increased cashflows. Usually, one would take out this debt because the purchase would have required huge capital outlays that the individual would not have access to ordinarily. If you buy a house as a primary residence or even as an investment property, this would be considered good debt as this will allow you to either save on your rental expense or to earn rental income. Debt used to finance the expansion of a business or to help as a bridging facility to ease cashflow needs in a business would also be considered good debt. Taking out debt to buy a vehicle that helps you to earn an income would be considered good debt if you manage it properly. In the same light, if you access debt to pay for an additional qualification that will help to improve your skills so that you can earn a higher salary this would definitely be a worthwhile cause for the use of debt. Debt has always been there and will always be there, but after reading this, I hope you will be more responsible about which debt you start using.

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