Debt is the borrowed money which is owed by the borrower to the lender and the same has to be paid back on the conditions decided while taking the debt or loan like monthly instalments, the tenure, the date on which it has to be paid, the interest that will be charged so on and so forth. Just like businesses or companies take loans to fund their big projects or even working capital requirements for the smooth running of their business, Individuals in their personal finance space do take loans for big purchases like a dream house or even for small purchases like a two-wheeler, electronic gadgets, or laptops and even marriages. Sometimes many people do take loans in case of emergencies like medicals and home repairs.
At first, it is important to avoid debt as much as possible. Best Debt is No Debt, the reason is pretty simple, once we take a loan we get into a debt trap laid down by banks and financial institutions. As human beings, it is very easy for us to get swayed by the luxury and lifestyle one can see in this materialistic world. But instead of preparing and planning to achieve and get the same lifestyle, people generally tend to achieve it by borrowing from their future income, that is by simply taking a debt on themselves. Humans are known for satisfying their greed instantly and getting immediate and instant gratification. The urge is so high they can't just delay it, not considering the fact that the urge and temptation are less rewarding now but if they practise delayed gratification they will be rewarded much higher and better. This can have a different discussion altogether.
However, not all debts are bad debts. Many times we take a debt or loan for leveraging our current situation and to increase our net worth or our future income. This kind of debt is generally considered GOOD Debt. Below are the few "Good Debts"
Business Loans: If you are taking a debt in your business to invest in a big project or expand your business this is considered as a GOOD Debt. The reason is simple this borrowed money if managed well helps us to take leverage and increase our business future income after paying off the interest. Ultimately, increasing the profits and valuation of the company.
Education Loans: If you take an education loan for higher studies for your child it is considered Good Debt. The cost of education is rising tremendously and it is not easy to fund your child's education. If you are planning for your child's post-graduation studies, the fees today are too high. In this situation, by taking a college debt one is leveraging on enhancing the skill set of their child which will help your child to generate more income in future. So, even after paying the debt, one will have that enhanced skill set to generate more income for themselves.
Home Loans: Today the price of real estate is too high. It is beyond one's affordability to buy at one go. Taking a home loan gives you ownership rights. Paying off the loans through monthly EMIs helps you to build long-term equity. Also, there is steady price rise which happens in the case of real estate not as fast as other investments though. In the long term, we have the full rights to the property bought, of which there is a capital appreciation. Hence buying a home or taking a mortgage loan is considered a good debt where we leverage our future income to create an asset which increases our net worth.
Now that you know what good debts are, you should know what Bad Debts are. The debt which is taken to buy or spend on a depreciating asset which decreases your net worth is considered BAD DEBT. Good Debt helps you to build your wealth whereas Bad Debt basically erodes your wealth. Below are a few Bad Debts that you should avoid.
Credit Cards: The first and foremost thing that you should avoid is the usage of credit cards. The rate of interest charged is exorbitant in the first place. Also if one gets into the credit cycle it becomes difficult to get out of the same. Many banks and financial institutions provide the customer to pay off the minimum amount due, carrying forward the balance and charging interest on the outstanding balance. This is known as revolving credit. and many people fall into this trap, paying off too much amount in interest. Also, credit cards spoil your spending habits. You spend too much on unnecessary products which we don’t need. Hence it is best to avoid credit card usage.
Auto Loans: Cars are considered a depreciating asset. The price of the car depreciates too fast. If you go to sell the brand new car the second day of your purchase you will fetch a very low value for the same. A car bought today and sold tomorrow or the day after will see a price correction of at least 10-15%, which is very huge. Over a period of time, the value of a car depreciates too much and gives us some basic value or scrap value. Hence it is a loan that one should avoid taking. On the other hand, car do have their utility and have an emotional connection with us as we share too many memories through a car like family outings, trips with friends, and attending some functions which can’t be compared and are just priceless.
Luxury Goods: Many people today have the habit of buying luxury items or electronic gadgets on loans. The “ Buy Now, Pay Later” schemes or “Loan pe Phone” are very popular today. We buy things which are very expensive that can be paid off in the next six to twenty-four months, not considering the fact that they will go over budget. The rate of interest for this kind of loan is pretty high. One should avoid getting into this trap of the Buy Now, Pay Later scheme.
Hence, it is important to identify the debts that we are taking. Is it a Good Debt or Bad Debt? Whether such loans are helping me to grow my net worth or are they helping me generate future income. If the answer is Yes, that will be considered as good debt and one can go ahead and take that loan and fund that specific need. Also one should take care whether it is not getting over-burdened or else that will backfire too. Bad Debts should be completely avoided.
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