When it comes to managing finances, there is an argument to be made that to have ‘zero debt’ is in your best interests. However, applying for loans and taking on debt is the only way most people can afford to purchase high priced items that are necessary, like homes and cars. While some debt, such as a mortgage, business or car loan, shows stability and maturity, having more debt than you can pay off can have many negative impacts on your life.

Managing money is a skill that everyone must learn in life and because most people will end up with some kind of debt, it’s vital to either brush up on your financial skills to better understand how consumer debt works or to seek the guidance of financial advisors.

When it comes to making lending decisions, credit providers use several ways in which to assess a consumer’s debt portfolio and determine the credit risk. This includes looking at the consumer’s debt-to-income ratio, their debt-to-asset ratio and assessing their recovery risk. Essentially, this gives you an idea of how many of your assets you would have to sell to cover the cost of your debt.

Determining whether debt is ‘good’ or ‘bad’ also depends on the individual’s financial situation, amongst other factors. Below we highlight some ways to distinguish between Good and Bad debt.

Good Debt
‘Good’ debt, simply put, is a loan that has the potential to increase your net worth by helping you to generate income. Homeownership is a well-known example of being in good debt, with the idea of buying a home, living in it for a few decades and potentially selling it off to make profit. Taking out a loan for educational reasons is seen as good debt, there being a positive correlation between improving your education and the ability to find employment. Starting up a business is another example of good debt with the ultimate aim of offering your products or services to generate profit.

Bad Debt
This generally involves borrowing money to purchase depreciating assets and if you won’t go up in value or generate income, you should probably reconsider spending your money. A prime example of this, and a necessary evil in South Africa, is purchasing cars. By the time you have driven your new car out of the dealership, it has already lost value and while it is important for everyday errands and getting to work and back, paying interest on a car purchase is considered a ‘waste of money’. Other examples of bad debt include credit card debt and purchasing consumables such as clothes, food and other goods and services.

Debt is inevitable and part of our lives as consumers. It is important to educate yourself on budgeting and debt management or otherwise seek financial advice and credit counselling.

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