Illustration by Mat Ealam
So let’s start with the most important question: why do you borrow money? Normally, you borrow money because you don’t have enough to buy something you want or need — like a university education. A four-year university education might easily cost you £40,000 or more. Not too many people have that kind of extra cash. So you borrow money to purchase that education in hope that a college degree will support your career in the future.
Then, how about a vacation? A quick internet search shows that your dream vacation to Bali will set you back by at least £700. Although more people may have the money to pay for that than the college education, what if you don’t? Should you finance a vacation the way you finance an education?
This is the most important point: there’s a big difference between borrowing for something that represents a long-term investment and borrowing for short-term consumption.
If you borrow and spend that £700 for a trip to Bali, the money is gone. Poof! You might have beautiful memories and photos, but you won't have any financial value to show for it. But, you would argue, “vacations replenish my soul and make me more productive when I return. A good rest would do me good and increase my working functionality!”
I’m not saying that you shouldn't take a vacation. By all means, you should take one, two, three, or as many as you can afford. But that’s it: Take what you can afford. If you have to borrow money in the form of an outstanding balance on our credit card for many months in order to take the vacation, you can't afford it. And that right there, is a very bad debt.
Bad debts are debts incurred for consumption or a higher-interest debt used to buy items that depreciate in value. Such debts are harmful to your long term financial health. The high interest rates (i.e: >7%) that banks and other lenders charge for bad (consumer) debt is one of the reasons you’re less able to save money when using such debt. Not only does money borrowed through credit cards, auto loans, and other types of consumer loans carry a relatively high interest rate, but they also are not tax-deductible.
Good debt, such as that used to buy real estate and to fund small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible. If well managed, these investments may also increase in value. Borrowing to pay for educational expenses can also grow your net worth in the future. Education is generally a good long-term investment, because it can increase our earning potential. And student loan interest is tax-deductible subject to certain limitations.
To calculate the bad debt danger ratio, divide bad debt by annual income
Bad debt danger ratio = Bad debt / Annual Income
When your bad debt danger ratio starts to go above 25 percent, it can be really troublesome. Such levels of high-interest consumer debt on credit cards and auto loans can snowball and get out of control very easily. It becomes possible to get into a debt cycle of barely making the interest payments of your loans.
Like good food, of course, you can get too much of a good thing, including good debt! When you borrow for investment purposes — to buy real estate, to fund small business, even for education — you hope to see a positive return on your invested dollars. But some real estate investments don’t work out. Some small businesses crash and burn, and some educational degrees and programs don’t help in the way that some hope that they will.
There’s no magic formula for determining when you have too much “good debt.” In extreme cases, there are entrepreneurs, for example, borrow up to their eyeballs to get a business off the ground. Sometimes this works, and they end up financially rewarded, but in most cases, they don’t.
There’s no magic formula, but there are some questions to ask ourselves before taking on another “good debt”
It’s important for our financial health to control how much debt we’re taking on, and even more important to be aware of whether it’s good or bad debt. If you have any questions tweet us at @quirkmoney.
Sign up to Quirky Fridays for a round-up of the week’s most important news on the economy and tips that will help with your personal finances. Every Friday at 4PM straight to your inbox.