Explained: Good debt versus bad debt

UAE consumer confidence

Having debt looming over you is never a good thing. In general, it’s advised that as soon as debt accrues, you should start paying it off to avoid both stress and other money troubles further down the line.

However, not all debt is created equal. Indeed, there is such a thing as “good debt”. And in fact, under the right circumstances, debt can have a positive impact on your finances. Here, we’ll go into what constitutes good debt and bad debt, and how you can manage the bad stuff in order to enjoy more of the good stuff.

Last year, it was calculated that the average UAE resident had nearly AED 43,000 in personal debt. And in a recent survey, expat residents worried about the amount of money that they spent on increasing housing fees and utility bills.

Unfortunately, debt for many people today is a simple fact of life. A lot of people don’t earn enough to pay for life essentials like a house, car or education straight off the bat. So it’s natural that most people would turn to taking out a loan to help them financially. On top of this, many UAE residents get used to a lavish lifestyle and fall into the trap of racking up debt trying to pay off multiple credit card bills and personal loans. This is how you get stuck in a viscous cycle of constantly paying off a debt that you can’t afford. That’s bad debt.

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Bad debt is debt that makes your financial situation worse. You acquire bad debt when you borrow money to pay for something that you don’t necessarily need, or when you simply can’t afford to pay back what you borrowed.

For example, getting stuck with paying off credit cards is classed as “bad debt”. With high interest rates, credit cards should only be treated as a short-term transactional debt. Put whatever you want on the card, as long as you know you can pay it all off by the due date. That way, you avoid adding extra interest. A good rule of thumb is to not put anything on your card that won’t go up in value – like a holiday or clothing. Credit cards make transactions abstract; you don’t physically see money leaving your wallet so you don’t feel the downside of spending the money. And before you know it, you are taking out a loan to pay off your bill.

Good debt is typically described as debt that’s used to finance something that will eventually increase in value. Good debt should leave you better off in the long term and shouldn’t have a negative impact on your overall financial position. When taking out a loan, it’s always best to have a clear specific reason for taking it out and you should be thinking of a realistic plan on how you’ll pay it back.

Mortgage debt is a classic example. You get a mortgage to buy a house, and hopefully, in 20 years, when you’ve paid it off, the house may be worth two or three times the purchase price. So, although you could go into debt to buy a house, you will eventually gain profit in the future. A student loan can be classed as good debt as well. You accrue debt when you’re younger, in the hopes of getting a decent job later, allowing you to pay off the debt and land yourself in a more financially secure situation.

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A car can also be classed as an investment. Although it does devalue in time, meaning you will lose money, if it is essential for you to own a car for work, then it adds financially to your future. You will still be earning money because of your car, so you’re still investing smartly. However, if you feel the need to buy a car unnecessarily, then the vehicle can no longer be classed as good debt. That’s when you will end up in bad debt, paying off a car that you can’t afford, and shouldn’t have bought.

The advantage of good debt is that it’s essentially seen as an investment, just like a stock or bond. You’re spending money now, hoping you will get your money back in return and perhaps with profit in the future. Usually good debt carries a much lower interest rate, making it easier to pay off in the future.

Even though good debt shows that you have careful planning and budgeting, it’s essentially still a loan that needs to be paid back at certain intervals, so you should still make sure you spend within your means. Just because a mortgage is seen as good debt, if you buy a home that doesn’t match up with your monthly salary then it can be classed as “bad good debt”. In the long run, you will end up in a financial struggle. Avoid buying a home, car or paying for your child’s education that consumes too much of your income.

If you don’t want to accumulate bad debt, then it’s best to think twice before you pull out a credit card to pay for unnecessary purchases and save your money for your future instead.

Are you ready to have good debt instead of bad debt? Click the link below to compare home loans and start investing smartly in your future

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