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Difference Between Good Debt and Bad Debt Research Team | Posted On Tuesday, January 21,2014, 04:30 PM

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Difference Between Good Debt and Bad Debt



Life is all about needs and wants. Many a time a need and a want are separated by a fine line. How does one distinguish a need from a want? It surely comes down to affordability. If one can afford his needs as well as he wants this topic is irrelevant. But what if one is an ordinary mortal battling rising prices and looking for a better deal in life? How would one balance day to day needs versus his dreams and aspirations? Now one needs to clearly demarcate needs and wants. There is a famous saying If you buy things you don’t need, soon you will have to sell things you need.

In order to make a decision to avail a loan or not one needs to know what is debt. This is basically borrowing money say from a bank to meet one’s wants or needs taking a bet that his future earnings would be able to help him pay back the borrowed amounts with interest. One can meet his present need say the purchase of a car even though one does not have the funds to pay for it immediately. But taking a loan entails risk. What if one loses his job due to a recession? What if one meets with an accident and is not able to repay the debt? This risk or uncertainty makes taking a loan a dicey affair. Remember “It is the debtor that is ruined by hard times”.

See Also: Are Millennials Landing Into A Debt Trap?

What is Good Debt?

One must have heard the famous debate on good debt versus bad debt. So what is this all about? Can debt ever be good or are modern youth right in fearing debt? Taking a loan is never a good idea but can be justified in certain circumstances. Taking a home loan is generally regarded as a good debt. The reasons generally given are a roof over ones head is a must and the purchase of a house is considered a basic necessity in life. With the cost of land and residential apartments soaring in metro’s and even towns and cities one might not be able to afford a house if he waits too long. By opting for a home loan when one is young even though he may not have funds in hand to make the whole payment and can only afford the down payment he might be able to purchase the house for a lesser price. If one opts for a home loan he also gets a tax deduction under Section 80C on the principal component of his home loan up to a sum of INR 1 Lakh. Interest portions are tax deductible under Section 24 up to INR 1.5 Lakhs.

How Does One Distinguish Between Good Debt and Bad Debt?

  • If one goes for a second house as an investment mainly to be given out on rent this is a good debt. One can claim the entire interest portion paid on the loan as a deduction against the rental value. With time one is the owner of the second house and collects rent on it as well as can sell it for a profit if he gets a good deal.
  • However is taking a home loan good under all times and circumstances. If one is young and has just started working he needs to make a choice of the size of the house and the location. If one goes for too extravagant a house when his career is young he may find the burden of the EMI’s too high to bear. There would be no funds for medical emergencies and other contingencies. The same good debt namely the home loan is now a bad debt.
  • Car loans are commonly taken and a good justification given on the use of the car. But does one really need a car? Is this car a necessity or merely taken because one’s neighbor owns one? If one hardly commutes and his office is a stone’s throw away and the city has excellent public transport then taking a car loan can be a bad debt. If a car is a necessity for commuting then it is regarded as a good debt.
  • Education loans are an investment in one’s future. They enhance one’s earning ability in his career. Remember an investment in knowledge pays the best interest. An education loan is regarded as a good debt.
  • Many a time one disregards the famous rule spend less than you earn. One wants the latest smart phone or a LCD Plasma television even though he cannot afford it right away. These are normally purchased using a credit card. Credit card debt is regarded as bad debt mainly because of high interest rates charged. One must try his utmost never to borrow using the credit card and if he has retire the debt quickly. If the smart phone is a want rather than a need then postpone its purchase. It is better to set up a fund for a good investment and when it appreciates pay cash and buy the gadget outright.
  • If push comes to shove always opt for a secured loan basically a loan backed by a security such as gold or a property. Generally a secured loan means one gets a higher loan amount versus an unsecured loan such as a personal loan which is not backed by a collateral. The interest rates are higher in the case of an unsecured loan compared to a secured loan. A high number of unsecured loans availed affect one’s credit score. These are considered bad debts.

Should One Avail of a Personal Loan to Invest in the Stock Market?

One may think of availing a personal loan investing it in shares and watch it double. One can then pay back the loan with interest and pocket the difference. But is this a good idea? Stock markets are known for volatility .If the market tanks one would lose all this money and fall into a debt trap from which coming out is very difficult. If one is thinking about this approach it is best to shelf this idea. Remember good times are when people make debts to pay in bad times.

There is a famous saying “Rather go to bed supperless, than rise in debt. One needs to take a loan only if it is a necessity rather than an indulgence. Though certain debt such as credit card debt is a strict no no good debt such as a home loan or a secured loan mainly depends on the life stage, circumstances and the ultimate use of this loan. Remember the fate of a loan to be converted to good or bad is in one’s own hands. So choose wisely.

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