Debt is often seen as quite a negative word. We might associate it with stress and poor finances, but actually, not all debt is equal. Debt itself isn’t inherently good or bad – while some debt can have a negative impact, other types of debt can be beneficial in the long- term. It largely depends on your circumstances too.
What is good debt?
What makes debt ‘good’ or ‘bad’ is very nuanced, but generally speaking, good debt improves your financial future, and is more common than you might think. Here are some of the main types of good debt:
Mortgages – most people buying a home will require a mortgage. Because mortgages are underwritten by lenders, and because the applicant’s ability to repay the debts is fully checked, this makes it a good type of borrowing. You’re also likely to be improving your financial future.
Student loans – borrowing to fund an education such as a university degree is generally considered to be a good type of debt too. Most students who attend university will need to apply for a student loan to pay for the course and their living expenses. You’re also taking steps to increase your earning potential.
As a general rule of thumb, good debt is usually taken to help improve the applicant’s situation, which is why it’s often referred to as good debt.
What is bad debt?
Again, whilst it depends on the context, bad debt is usually very expensive and taken out for short term gain. It is often used to cover a gap in finances.
Payday loans – payday loans are a good example of bad debt. These are usually targeted towards borrowers who lack access to other forms of credit. They typically have very high interest rates and need to be repaid quickly. When borrowers struggle to make these repayments, they often end up borrowing more and fall into cycles of debt and repayment.
Buy Now Pay Later – similarly, Buy Now Pay Later is usually considered bad debt. Buy Now Pay Later providers typically charge higher interest rates, and because there are often late payment fees, it can quickly become expensive. It’s also often used to purchase non-essential items that aren’t likely to improve your financial future in any way.
Credit cards if not used carefully – credit card usage is extremely common, and it can be a good thing. For example, some credit cards provide travel miles and other bonuses, and if you pay your balance in full every month, you can improve your credit score too. However, using a credit card to pay for a holiday or car for example, then paying this off over a long period of time can be seen as a bad type of debt due to the high interest rates normally charged on credit cards. If you consistently find you’re only paying back the minimum required each month, this is likely to be considered bad debt.
Unarranged overdrafts – if you spend more money than you have in your overdraft without first agreeing it with your bank, this is known as an unarranged overdraft.
Arranged overdrafts – Regularly using an arranged overdraft can indicate to potential lenders that you’re struggling to manage your finances well.
There are many types of debt, for example car loans, and personal loans, and many don’t fall neatly into either good or bad debt. It’s important to consider the context of your unique circumstances.
How much does debt affect my credit score?
As we’ve touched upon, debt can affect your credit score positively, but also negatively.
If you have no credit score, or a low credit score, this could be due to your age, or not having had a need to borrow previously. In this case, borrowing in the right way (e.g., by taking out the right type of loan and ensuring you keep up with repayments) can potentially have a positive impact on your credit score. It shows lenders that you’re a responsible borrower, and therefore a lower risk to them.
However, this works both ways. For example, if you miss payments, this can negatively affect your credit score as it suggests to lenders that you may not be managing your debt efficiently.
For additional information about credit score, read our article on why credit score is important.
What type of debt should I pay off first?
When looking to repay debt, it’s important to always keep making the agreed minimum repayments. Never simply stop making repayments without speaking to your lender.
However, there are some debts which it may be beneficial to clear first. These are short term, high interest debts like payday loans and some credit cards.
These are usually the most expensive types of borrowing and therefore should be repaid first if you have the funds to do so. It’s better to pay off your credit card than to overpay on your student loan repayments each month, for example.
Understanding the difference between good and bad debt can help you borrow responsibly, whilst also improving your credit score.
