Buying anything using debt is risky. We have seen how debt has caused havoc in some of the world’s biggest economies. So it can’t be all good. It is important for individuals to not take the short cut route of piling up debt to make a quick buck or fulfill their desires.
As much as possible, one must avoid debt. When you borrow, you basically end up paying interest that take a toll on your savings. Instead if you be patient and develop a habit of saving, you will be in a position to buy things that you want without giving your hard earned money to someone else as interest payment.
Although one must avoid debt as much as possible, some debt can be good for building wealth. And considering today’s lifestyle and the ever increasing cost of living chances are, at some point in your life, you will have debt. The important question that needs to be answered is when is it acceptable to take debt? It is imperative to first know the difference between good debt and bad debt.
Good Debt vs Bad Debt
GOOD DEBT – A good debt is an investment that creates value over time, which you can afford like a home loan or student loan (if you have no other means of financing them). Good debt is ideally low-cost and has potential tax advantages. Education is a very important investment and if you cannot afford one, you can consider taking a student loan for a better financial future. You can get a student loan at comparatively low interest rate and even the interest paid on this loan is tax-deductible. Benefits include enhanced career opportunities and increased earning potential.
Taking a loan to buy a house will also make sense because you’re borrowing to own a potentially appreciating asset, and it may be tax deductible. Besides you save the cost of monthly rent which can go towards paying your EMI.
BAD DEBT – Using credit card to make any kind of purchase and not paying the bills on time is a classic example of a bad debt. You end up paying high interest rates for purchases that will only depreciate in value.
As a rule of thumb, borrowing to own something that depreciates is considered bad debt and creates an unhealthy financial situation. The moment you buy a car, its value immediately depreciates, so it isn’t a very good idea to buy a car using loan.
And what could be the worst kind of debt you can take? Borrowing to invest in capital markets or to gamble for making quick money is lethal.
How much debt is too much?
As a rule of thumb not more than 30% of your pre-tax income should go to all debt: your home debt plus credit card debt and auto loans.
So make sure to not get into the debt trap as much as possible, and if you must use it very carefully.