Day 11: Understanding Good vs. Bad Debt
Debt is a common financial tool used by
individuals and businesses alike, but not all debt is created equal.
Understanding the difference between good debt and bad debt is crucial for
making informed decisions about borrowing and managing finances. In the context
of India, where cultural attitudes toward debt can vary and access to credit is
expanding rapidly, this understanding becomes even more vital.
In this post, we will explore the distinction
between good and bad debt, when borrowing makes sense, and provide a practical
case study to illustrate the concepts.
What is Good Debt?
Good debt refers to borrowing that is used for
purposes that improve your financial future. This type of debt typically helps
you build wealth, increase your earning potential, or finance an asset that
appreciates in value over time.
In India, common examples of good debt
include:
- Education Loans: Student loans (or education loans in India) are
considered good debt because they finance your education, which is an
investment in your future earning potential. The ability to secure a
higher-paying job or career advancement as a result of education can
outweigh the cost of the loan.
- Home Loan (Mortgage): A home loan is a common form of debt that
many Indians take to purchase real estate. While it involves long-term
repayment, real estate in India has historically appreciated in value,
making it a good investment.
- Business Loans: If you're starting or expanding a business, taking
a loan can be a form of good debt. This is because the business has the
potential to generate enough revenue to cover the debt payments and
generate profits in the long term.
When Borrowing Makes Sense (Good Debt):
- When Interest Rates Are Low: Low-interest rates make borrowing more
affordable, and if the interest on the loan is lower than the return you
expect from the investment, borrowing can be a good decision. For
instance, home loan rates in India have been historically low, making it
an attractive option for purchasing property.
- For Investments That Appreciate in Value: Borrowing to invest in
assets like education or real estate is a wise move if the value of the
investment is expected to grow. For example, buying a house in a growing
city or enrolling in a degree that enhances your career prospects can lead
to substantial financial benefits in the future.
What is Bad Debt?
Bad debt, on the other hand, refers to
borrowing that drains your finances and does not improve your financial
situation. It is typically used for non-essential items or to finance
consumption rather than investments that appreciate in value.
In India, examples of bad debt include:
- Credit Card Debt: High-interest credit card debt is one of the most
common forms of bad debt. In India, credit card interest rates can range
from 30% to 40% annually, which is much higher than personal loan interest
rates or home loan rates. This makes it difficult to pay off the balance,
especially if the debt is used to fund non-essential spending like eating
out, vacations, or luxury items.
- Payday Loans: Payday loans, which are short-term loans with
extremely high-interest rates, can lead to a cycle of debt. Though they
may seem like a quick fix for immediate financial needs, they can quickly
spiral out of control due to high fees and interest rates.
- Personal Loans for Consumption: Taking out personal loans for
things like shopping, vacations, or buying expensive electronics without a
clear plan to repay them is a form of bad debt. These loans don’t
contribute to wealth-building and often come with higher interest rates,
adding to your financial burden.
Why Bad Debt is Dangerous:
- High-Interest Rates: Bad debt often comes with high interest rates
that can increase your outstanding balance over time. For example, if you
carry a balance on your credit card for several months, the interest
compounds, and you may end up paying much more than the original amount
borrowed.
- No Asset or Investment Value: Unlike good debt, bad debt does not
result in the accumulation of an asset or investment that can generate
future returns. This makes it more difficult to justify paying off the
debt.
Case Study: Rajesh's Home Loan and Credit Card
Debt
Let’s dive into a case study of Rajesh, a
30-year-old software engineer from Bengaluru, to see the difference between
good and bad debt in action.
Background:
Rajesh is working at a well-paying job in a
tech company and has a steady income. However, like many people in India,
Rajesh has accumulated both good and bad debt.
- Rajesh’s Home Loan (Good Debt):
- Rajesh recently bought a 2BHK apartment in Bengaluru using a home
loan of ₹40 lakhs from a public sector bank at an interest rate of 7.5%
per annum.
- The property is located in a rapidly developing neighborhood, and
the value of real estate in this area has appreciated by 5-7% annually
over the last few years.
- Rajesh sees this home as a long-term investment. He plans to live
in it for at least 10 years and sell it or rent it out in the future,
expecting a good return on his investment. The interest rate on the loan
is relatively low, and he is able to pay off the monthly EMI comfortably
with his income.
Why This Is Good Debt:
- Rajesh’s home loan is enabling him to purchase an asset (the
property) that has the potential to appreciate in value.
- Real estate in Bengaluru is expected to continue growing, and
Rajesh could either sell the property for a profit or rent it out for
passive income in the future.
- Rajesh’s Credit Card Debt (Bad Debt):
- Rajesh also has a credit card balance of ₹1.5 lakhs. He primarily
used his credit card for dining out, entertainment, and some
non-essential purchases.
- He’s carrying this balance month-to-month and only making the
minimum payments, which results in high-interest charges. The interest
rate on his credit card is around 35% annually.
Why This Is Bad Debt:
- Rajesh is paying a high amount of interest on his credit card
balance, and the purchases he made with the card are not contributing to
his long-term financial well-being.
- Unlike his home loan, this debt is not tied to an appreciating
asset. Instead, it is for consumption and does not provide any future
value. This debt is draining his finances with high-interest payments
that could have been avoided.
When Borrowing Makes Sense in India
As Rajesh’s case shows, not all borrowing is
bad, but it’s important to understand when borrowing makes sense:
- Low-Interest Rates: If interest rates are low, such as the current
home loan rates in India (around 7% to 8%), it might make sense to borrow
to purchase real estate, which can appreciate over time.
- Investment in Education: Education loans are another example where
borrowing makes sense. Higher education in India is becoming increasingly
expensive, and taking a loan for a professional degree or specialized
skills can lead to higher-paying job opportunities in the future.
- Starting or Expanding a Business: If you are starting a business or
expanding an existing one, taking a loan with a clear repayment plan and
expected returns is a prudent way to grow your wealth.
When Borrowing Doesn’t Make Sense:
- Borrowing to fund lifestyle expenses like vacations, shopping
sprees, or dining out is usually not a wise decision.
- High-interest debt, like credit cards and payday loans, should be
avoided at all costs. They tend to spiral out of control, leading to
long-term financial struggles.
Conclusion: Balancing Good and Bad Debt
Debt can be a useful financial tool when used
correctly, but it’s important to understand the difference between good debt
and bad debt. In India, where borrowing is increasingly accessible, people must
evaluate whether taking on debt is truly beneficial to their financial future.
Good debt, like home loans or education loans,
can help build wealth and improve your financial situation. Bad debt, such as
credit card balances and payday loans, drains your finances and can lead to
financial difficulties.
By understanding when borrowing makes sense
and managing debt wisely, you can use debt strategically to enhance your
financial position while avoiding the dangers of high-interest, non-productive
debt.
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