The difference between good debt and bad debt
- What’s the Difference?
- What Is Good Debt?
- What is Bad Debt?
- How Do I Choose the Right Debt?
- Frequently Asked Questions (FAQs)
When you're looking to invest in your business's future, at some point, you need to consider taking on debt. Despite the negative connotations that come with the word, debt isn't always a bad thing. This article examines the difference between good and bad debt to help inform you how different financial facilities could impact your future finances. In doing so, we break down the risks surrounding commercial mortgages, vehicle loans, government-backed loans, private loans, microloans and high-interest credit cards. We conclude by helping you figure out whether taking out debt is worth it.
The concept of debt is nothing new. In fact, some scholars believe that debt and credit existed before money itself. Throughout its long history, personal debt has generally been considered to be a bad thing. From the pressure it can put on household finances to its role in reducing social mobility, it's easy to understand why people make these claims. However, as an increasing amount of financial solutions become available, debt continues to help people invest in their future and manage their finances more effectively.
While bad debt certainly exists in the commercial sector, business loans have a notably better reputation than personal loans. When it comes to your business, debt can be instrumental in helping it get off the ground, expand or make it through the tough times. That said, it's essential to know the difference between good debt and bad debt to make sure your financing option is helping you pave the path toward success and not failure.
Read on to learn about the difference between good and bad debt and the impact it can have on your finances.
As a general rule of thumb, if a debt has future value or increases your net worth, it's considered good. Alternatively, if debt doesn't feature investment or is only used to purchase material things, it is generally considered harmful. To understand this in more detail, let's take a closer look at good debt.
Good debt is debt that's used to pay for something with a long term value. For instance, when you can't afford something upfront, such as education, a house or a car, they can borrow money to make these necessary investments. When it comes to business, good debt can also be used similarly. For instance, by using borrowed money to buy important resources, business owners can invest in the future growth of their enterprise.
Another thing that differentiates good debt from bad debt is affordability. If financial solutions like loans offer favourable interest rates and little or no fees, they are typically considered good debts. This is because there's a much lower chance they will come back to haunt you further down the line.
Here are some examples of business debts that can pay off in the future:
As far as debts go, commercial mortgages are one of the safest options out there. Commercial mortgages are loans taken out by businesses looking to purchase property. Since commercial premises are one of the most significant purchases a company will make, this type of financing allows them to own their land, building or development without covering the cost up-front.
Commercial mortgages are widely considered a good form of debt because they tend to leave the recipient better off in the long term. In contrast, other options like renting, mortgages allow business owners to own properties and invest in their future. Since the value of properties generally increases over time, this is often considered the more sensible option.
However, while commercial mortgages make better financial sense in the long run, taking on an unaffordable mortgage can lead to catastrophic consequences. Moreover, since the property market is unpredictable, there’s always a chance the value of your asset could decrease over time.
Commercial Vehicle Loans
Whether your business is established or you're just getting off the ground, chances are you could benefit from a company vehicle. However, after staff wages and rent, vehicles are considerable expenses for small businesses owners. This is why commercial vehicle loans, or vehicle financing, are such popular options for businesses.
Commercial vehicle loans are available for businesses that can't afford to make the purchase outright. These loans are generally seen as a positive type of debt because they enable businesses to stay on the road. From cars and vans to heavy commercial vehicles, businesses can use the loan to finance several different vehicles for various purposes. Therefore, even if taking out a commercial vehicle loan doesn't come cheap, the practical benefits it delivers typically make it worth it.
However, commercial vehicle loans are not always considered a good type of debt. For instance, if businesses lease out vehicles far beyond their means, or if they don't get a lot of use out of the means of transport, the finance can quickly turn into a form of bad debt.
Private Business Loans
If you want to take your business to the next level and don't have the means to do so yourself, you can take out a business loan. Business loans are loans catered towards commercial organisations. Banks and private lenders issue them, and they can come in both secure and unsecured forms. Since launching a business or investing in its growth often requires a significant amount of capital, these types of loans are often necessary financial solutions for business owners.
By taking out business loans, entrepreneurs can invest in any area of their company, from their equipment to their workforce. By supporting these critical areas, the loans often provide business owners with promising returns on investments. This is why business loans are often considered positive types of debt.
That said, while business loans have the power to fuel the future growth of a company, some loan companies burden companies with hefty interest fees and start-up costs. To avoid this, it's crucial that your business only borrows capital from trusted, reputable lenders like MarketFinance.
Government-backed loans are loans that the government subsidises. They help provide capital to businesses looking for affordable funding options and are available through several private lenders. Depending on the type of loan scheme, this type of financing can help entrepreneurs launch, grow or expand their enterprises. While the loans are expected to be paid back in full, their terms make the debt easier to manage.
The main reason government-backed loan debts are easier to manage is because of their repayment terms. Unlike most private loans, businesses can make interest-only payments for the first six months of their arrangement. This makes it easier for business owners seeing delayed returns on their investments. Moreover, government-backed loans typically offer affordable interest rates. This makes it much less likely for business owners to enter debt spirals.
If your business has been impacted by the Covid-19 pandemic and is looking to kickstart its recovery, the Recovery Loan Scheme might suit you. To find out how this government-backed loan scheme could benefit your business, learn more here.
Now we've covered how borrowing can be used to make long-term improvements to your business's finances, let's take a look at some somewhat questionable types of debt.
Bad debt is essentially a form of debt that doesn't improve your financial profile in the long run. Unlike more secure solutions like mortgages and business loans, bad debt doesn't add to your overall assets or prospects. Instead, bad debt is typically used to buy products that depreciate or to fund people's current lifestyle.
Less favourable forms of debt also often feature high or variable interest rates and additional costs. Not only does this make it harder to take out the loan in the first place, but it has the potential to keep individuals in cycles of debt.
To understand how this may look in practice, let’s take a look at some examples.
As the name suggests, microloans are a type of finance that allows people to borrow small amounts of capital. They cater to individuals or businesses with low credit scores that struggle to secure funding from more traditional sources. While the size of microloans varies, they can start at a couple of hundred pounds and are typically capped at £50,000 or less.
Microloans can be helpful to borrowers that would otherwise be backed into a corner. However, since micro lenders need to protect themselves against the risk of not being paid back, they often charge much higher interest rates than average bank loans. On top of this, if the borrower misses a repayment, they can be saddled with hefty fines. Due to these additional charges, they can be a costly form of borrowing in the long run. Therefore, since microloans rarely improve the borrower's net income, they are considered a bad debt.
Another form of borrowing that often hinders businesses is short-term loans. Otherwise referred to as business cash advances, these short-term loans are taken out by businesses that require cash quickly. They're generally used as an immediate financial solution and are expected to be paid back within a month. Similarly to microloans, they have a very low barrier to entry and rarely have any credit requirements. This makes them very attractive to businesses with poor credit histories.
However, while payday loans are a quick and convenient way to gain access to short-term capital, they're also a bad type of finance because they can keep borrowers in cycles of debt. They often feature incredibly high interest rates, making it hard for unprofitable businesses to keep on top of payments. What's more, while policies vary from lender to lender, some short-term loan companies take money directly from the borrower's bank account or use aggressive collection methods if repayments can't be retrieved. This makes them a less favourable option compared to bank loans or traditional business loans.
High-Interest Credit Cards
The last type of bad debt we are going to discuss is high-interest credit cards. There's no denying it; credit cards can be an excellent option for small businesses. And just like personal credit cards, business cards can help companies resolve their cash flow challenges by giving them access to instant lines of credit. Additionally, most business credit cards feature a generous spending limit, so companies can use the card as they grow.
Unfortunately, unless you use a 0% interest purchase credit card, your business card will likely carry high interest rates. This is because credit card debt is usually unsecured and riskier for the lender to provide to businesses. Like the two financial facilities we've discussed above, these high interest rates make debts more expensive over time. While this isn't a problem if businesses pay back their debts quickly, if companies let the charges pile up, the interest payments can quickly outstrip the initial loan value.
As we’ve outlined above, debt is neither wholly good nor bad. Debt can be used as a tool to help individuals and businesses invest in their future. Yet, continual borrowing can also trigger debt cycles which can be incredibly hard to exit from. Moreover, even in cases that involve good debt, bad financial decisions can lead to undesirable outcomes further down the line.
When choosing if taking on debt is worth it, it’s sensible to ask yourself these two questions:
- Can I afford this debt?
- Will it add to my future value?
If you choose an example of good debt we covered in this article, the financial option will likely pay off in the long run. If you're looking for a concrete way to measure if you can afford the debt, you could base your decision on your debt-to-income ratio.
Your debt-to-income is a sum of your monthly debt payments divided by your gross monthly income. For the debt to be considered productive or 'good', your debt-to-income ratio should be lower than 43%. Here’s an example:
If your monthly expenses include a £750 mortgage payment, a £200 car payment and a £50 credit card fee, your total monthly debt will be £1000. If you’re earning around £2000 a month, your debt-to-income ratio is 50%. This is a bad debt ratio. Conversely, if you’re earning £3000 a month, your debt-to-income ratio would be 33.3%, which is a much more manageable figure.
What is considered good debt?
Simply put, good debt is a debt used to pay for something with a long term value. It allows individuals and corporations to invest in something they otherwise wouldn't be able to afford, like a property, an education, or the growth of their business. Good debt also typically offers borrowers affordable interest fees, so they don't get too bogged down with regular payments and hefty fees.
What is an example of good debt?
An example of a positive form of debt is business loans. Business loans are a type of borrowing that is catered towards commercial organisations. Banks and private lenders issue them, and they can come in both secure and unsecured forms. By taking out business loans, entrepreneurs can invest in any area of their company, from their equipment to their workforce. By supporting these critical areas, the loans often provide business owners with promising returns on investments. This is why business loans are often considered positive types of debt.
What is considered bad debt?
Bad debt is a form of debt that doesn't improve your financial profile in the long run. Unlike more secure solutions like mortgages and business loans, bad debt doesn't add to your overall assets or prospects. Instead, bad debt is typically used to buy products that depreciate or to fund people's current lifestyle. Less favourable forms of debt also often feature high or variable interest rates and additional costs. Not only does this make it harder to take out the loan in the first place, but it has the potential to keep individuals in cycles of debt.
What is an example of bad debt?
An example of a bad form of debt is microloans. Microloans are financial solutions catered towards individuals or businesses that struggle to secure funding from more traditional sources. Microloans are considered bad forms of debt because they rarely improve the net income of the borrower. This is because they typically feature high interest rates and incur additional charges for late payment.
How do I work out if a debt is good or bad?
If you're trying to figure out whether taking on debt is a good or bad idea for you or your business, you should start by establishing if it will bring you greater value in the long term. If it provides you with the means to invest in your future, there's a good chance it could be a good option for you. Another critical factor to consider before amassing debt is if you'll be able to afford it. A good way to work this out is by measuring your debt-to-income ratio.