Good Debt and Bad Debt

Good debt, bad debt

The very first step on your journey towards prosperity is to deal with any debts you have, especially bad debt. Now when I refer to bad debt I am not thinking of people who might owe you money which you don’t believe you will ever see again.

Bad debt is basically debt which just funds your lifestyle.  It is very expensive to maintain and repaying it should be your first priority with any capital sum or regular savings that you have available.

 

Outstanding credit card balances and store card balances should be dealt with first. But car loans are also detrimental forms of debt because the car is a wasting asset and the loan simply enables you to purchase a better car than you can really afford. 

Personal loans, payday loans and borrowing against the equity in your home all seek to fund a lifestyle that your present income cannot support.  You are, in effect, borrowing against your future and this is highly destructive to your journey towards prosperity.

Just look at the following Annual Percentage Interest Rates (APRs) that are currently charged on balances that are left unpaid on credit cards and these are simply typical of the breed.

There is simply no point in trying to build up any savings or investments with outstanding balances on such cards.

Just look at an example.

Michael has an outstanding credit card balance of £20,000.  He has decided not to use the card again until it is repaid. His wife will use her card for the weekly food shop, and other essential shopping only, until they can get straight.

If Michael pays the minimum repayment of 5% each month (i.e. £1,000 initially but then a reducing amount each month) it will take him 12 years and 5 months to clear this debt and will incur £7,986 interest.

If instead, he continues to pay a flat £1,000 a month he will clear the debt in 2 years exactly and pay £3,791 of interest.  Even on this basis that’s a lot of wasted interest for items he could perhaps have done without.

So what is good debt?

Well, unless we are fortunate enough to have inherited wealth or to win a substantial amount on the Lottery or Premium Bonds most of us need to take out a mortgage to buy our family home. The interest rates for this are usually very much lower than other forms of debt. Especially with a Repayment Mortgage the debt with automatically be repaid one day and this would qualify as ‘good debt’. 

Good debt is that which is used to increase your future standard of living and having a nice home purchased with a mortgage which is within your means will do that and it will provide a secure base for you and your family.  Student debt could be classed as ‘good debt’ because it can increase your future earnings through better paid work or a profession. Business loans can be used to kick start a small business. A mortgage on a buy-to-let property could be used to generate rental income, although I am not a great fan of borrowing to purchase any form of investment because of the risks involved.

Of course, if you overstretch yourself by taking out a mortgage which is really beyond your means to pay in the long term then this is starting to look more like ‘bad debt’. Whilst residential property prices have risen over the long term you can get into serious trouble with mortgage payments that are stretching you, for example, if one partner has to give up work to start a family.

Whilst home repossessions in the UK were just 4,580 in 2019, there have been 9 years in the last three decades when the number of repossessions were at least 40,000 in a year (www.ticfinance.co.uk/stats/).

It is a good idea to overpay your monthly mortgage payments while you can as this will shorten the term of the mortgage and save you a lot of interest. However, before doing so you should check that your lender allows you to overpay it penalty-free, and whether there are any limits as to how much you can overpay.

The only situations where this might not be appropriate are where the mortgage is on a fixed rate with a heavy penalty for repayment at present. Or where the mortgage is on a repayment basis and the monthly repayments are easily affordable by you.

Consider the following example.

Eric and Amanda have recently taken out a repayment mortgage of £200,000 over 25 years. The interest rate is fixed at 3.5%.  Eric has just had a promotion and can afford to do something with another £200 per month.  He could invest it in a Stocks & Shares ISA.

However, upon checking he has found out that the bank will allow them to overpay their mortgage by this amount. If they do make the mortgage overpayments of £200 a month they will repay their mortgage 5 years and 11 months earlier and save £26,217 in interest payments.

Whether it is the right thing to do will depend on their attitude to risk and whether they are more likely to continue with the mortgage overpayments or with the monthly ISA investment.

If you are wanting to start on your journey towards prosperity then you should identify any debt you have which was taken out to support a lifestyle you cannot really afford and reduce it as quickly as possible. 

Your mortgage or other debt which is calculated to increase your future standard of living can be kept but make sure it is affordable and still work at reducing it as much as possible as you don’t know what the future may hold for you.

Arthur Childs

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