This is another one of those very contentious topics that gets a lot of extreme opinions. So is debt a good or a bad idea? And like many other subjects in personal finance; it depends!
Debt comes in many forms. The most simple kind of debt could be a small amount borrowed from a friend or a family member. Another type and probably the more common type is credit card debt. And then the larger debt like a loan to buy a car or a mortgage to buy a house. So which of these could possibly be good debt? Well, it depends. My personal preference is to separate debt into 2 kinds; debt that is used merely for consumption and that used to purchase a depreciating asset and on the other hand debt used for a productive purpose or to purchase an appreciating asset.
First of all, all debt needs to be repaid at some point and comes with a cost. So the first and probably the most important consideration is whether you can afford it. Very often, the start of a serious financial crisis starts with a loan that one can't afford to pay back. And hence it is important that you have confirmed that you can afford to pay back the loan including the interest. Very often there are variable components to the loan, eg the interest rate. As time passes the interest rates may increase thus increasing your monthly payments. Moreover, you need to assess the risk to your income that helps you to pay back the loan. Is there a reasonable risk that you will not be able to pay back the monthly instalments in the future?
An important consideration is the financial impact of the asset that you are buying. Are you taking on debt to pay for a holiday? Or to buy a depreciating asset like a car. Remember it may feel exciting to go on a holiday using borrowed money but as soon as the holiday is over in a few days, you will be left with the burden of paying off the loan over a period of time. Pleasure for a few days and financial burden for a few years. Will this be worthwhile? Also understand that the value of car will depreciate the moment it leaves the showroom. And it will continue to lose value over time while you continue to bear the burden of the debt for many years. In other words, these are examples of non productive debt and I advice people to refrain from taking on such debt.
On the other hand there is productive debt. Debt that allows you to produce more or create an asset in the future. A good example is a mortgage. A mortgage allows you to build an asset over time, something that appreciates in value over time. Although a mortgage is as risky as any other debt in terms of risk of affordability, if used wisely, it can help you to build a asset over time and hence I call it good debt as long as you use it wisely. Make sure that the monthly exposure that you have in terms of monthly repayment is set in such a way that you can still afford to pay the EMI even if the rate of interest changes over time. Have enough buffer to account for unforeseen increases in the interest rates. Then again, should you buy a house or rent it? Read my post here to know more.
The worst kind of debt is credit card debt which should be avoided at all costs. The interest costs associated with credit card debt are exorbitant and the cost can spiral up very quickly if not managed carefully.
In summary, debt can be good or bad depending on how you use it. Any questions? Post your query in the comments section below.
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