When Good Debt Becomes Bad Debt
Many of us think of debt as a curse. We are on a merry-go-round of owing money we do not have, and it never seems to stop spinning.
However, not all debts are bad. In fact, some are inevitable and can even be “good”. It is important that you understand the difference between the two so you can make good choices when you borrow money.
Good debt versus bad debt
Debt is often referred to as a sum of money that is owed or due. Good debt is money that you borrow to purchase assets that appreciate in value or has some income producing potential such as a mortgage loan or a student loan.
For example, rental property owners can leverage on their mortgage through tax deductions that they can claim from direct expenses that are wholly and exclusively incurred in the production of their rental income. They include assessment and quit rent, interest on loan, insurance premium, and expenses on rent collection, rent renewal, and even on repair works.
Bad debt on the other hand, is money that you borrow for consumption like spending on cars, furniture, a new iPhone or a trip to Bali. This could be from a bank loan or a personal loan, though they are not necessarily bad in themselves. Bad debt do not create value and cannot be recovered.
However, good debt can easily turn bad if you consistently make late or incompletely payments, while bad debt can get even worse with compound interest that could incur an additional thousands of Ringgit.
When good debt goes bad
Just because they fall under the “good debt” category doesn’t mean you should blindly take them on.
Borrowing money to buy a home, a rental property, or to fund one’s education are generally listed as good debt because they create value for the owner. However, borrowing far more money than you can reasonably afford to pay off in a timely and orderly manner can throw you off track and ultimately land you in bad debt.
Ideally, your monthly home loan instalment, including principal, interest, real estate taxes and homeowners insurance should not exceed 28% of your gross monthly income. If your monthly gross income is RM5,000 you should not be paying more than RM1,400 on housing in a month, to avoid getting sucked into the bad debt trap or risk foreclosure (for mortgages).
A student loan can also turn bad if you can’t find a job that pays well enough to pay your student loan off, and years after graduation you are still stuck with student loan repayments.
Ultimately, all debts become bad debts when you don’t have the cash to pay it back. Good debts that turn bad can put you in a deep, dank financial hellhole the same way that bad debts can.
Bad debts could get worse
As Murphy’s Law would have it, bad debt could get worse. Credit card debt in particular, has a reputation for turning from bad debt into a nightmare.
Using a credit card itself doesn’t necessarily mean you are doomed to a debt disaster. In fact, plenty of people turn to credit card rewards and privileges to their advantage, and successfully save money.
The problem arises when cardholders fail to make their monthly repayments on time. This could affect your credit rating, which can make life extremely difficult from getting a loan or another credit card. The sky-high interest rate you accumulate from credit card debt can drag you further down your financial nightmare.
Let’s assume you owe the bank RM10,000 in credit card debt and have accumulated an annual interest rate of 18%. If you pay a minimum repayment of 5% or RM500 per month, it will take you seven years and four months, and an additional RM4,055 in interest to clear your debt.
How to manage very bad debt
You will need to pay off your debts at some point, but where do you start? Should you pay off your credit card debt or ditch the student loan first?
To begin, you should identify high-interest debts such as an outstanding credit card balance and aim to clear that off first, so you pay less interest in the long run.
If you’ve accumulate a substantial amount of debt on a high-interest credit card, you may consider applying for a balance transfer with a lower interest rate to help you save on your existing debt and clear your debt faster.
For example, the Maybank 2 Cards offer up to 0% interest rate for up to 12 months. However, most balance transfer credit cards require good to excellent credit ratings for approval and your interest rate will rise again if you fail to clear your debt in three years’ time.
Getting a personal loan is another option that you can consider to pay off your high-interest debt, as long as the new loan interest is lower than your current debt interest rate. Personal loan rates start from as low as 7.68% per annum, but can go up to as much as 12%. Longer loan tenures would mean more interest being paid.
As with most things in life, debt too, requires balance. For many adults, debt is part and parcel of life, as few can afford to pay cash for everything they purchase. With that in mind, the motto of “everything in moderation” is the right approach to take where debt is concerned. But remember, even “good” debt can pull a Rihanna and rear its potentially bad downside.