For many Filipinos, debt is debt and there’s no gray area. However, there’s actually such a thing as good debt—and there’s also definitely bad debt. The former can help you become more financially secure, while the latter can cause you to worry and drive you deeper into debt.
To make things easier to understand, here are some important things you should know about good debt and bad debt:
What Is the Difference Between Good Debt and Bad Debt?
Keep in mind the old saying: “It takes money to make money.” Thus, the explanation for good debt is simple: if it increases your net worth, helps you generate income, or adds future value, it’s good. Everything else that doesn’t fall under this definition is bad debt.
You should also consider your debt-to-income ratio. To compute this, get the total of all your monthly debt payments—not expenses, debt payments—and divide it by your monthly gross income. For example, if your total monthly debt is Php 25,000 and your gross monthly income is Php 50,000, then your debt-to-income ratio is 50%.
If you have a high debt-to-income ratio, you’re at higher risk to miss out on monthly payments and all your debts may become bad debts.
What Are Specific Examples of Good Debt?
When you consider the definition above, many of the loans Philippines’ banks and financial institutions offer are actually good debt. The key is to learn how to manage your finances so that you don’t add to your bad debt in your effort to increase your net worth. That said, here are some good examples of good debt:
1) Small business loans. When you take out a small business loan (some banks call this SME loan), you can increase your cash flow, expand your inventory, or purchase new equipment. All these activities have the potential to make your business become more profitable.
2) Personal loans. A personal loan can either be good or bad debt. An example of a personal loan becoming good debt is when you use it to further your education. That’s because it will increase your earning potential in the future. However, make sure to evaluate yourself. If you won’t be able to commit to finishing your course, then it might be better to not push through with the loan.
3) Home loans. One of the basic necessities is shelter, which is why a home loan is usually seen as good debt. Having your own house also helps you build equity, not to mention stability.
What Are Specific Examples of Bad Debt?
Bad debt is something that doesn’t add to your future income or wealth. For example, if you take out a loan for a new gadget even if the one you currently own doesn’t need to be replaced, you’re incurring bad debt. There are many examples of bad debt, but the most common ones you will encounter are the following:
1) Instant loans. Instant loans are those that you can avail of within the day, usually through a mobile app. They have quick approval processes and minimal requirements, but they have high interest rates. Sometimes, you end up paying almost double the amount you borrowed. If you aren’t careful or if you overestimate your paying capability, you might end up in more debt.
2) Non-essential credit card purchases. There are times when using your credit card can be a good thing. However, if you often use it to fund your lifestyle, then you’re likely adding to your bad debt. What’s even worse is if you’re only making minimum payments because then you’re prolonging the period that you’re paying interest.
Is Good Debt Risk-Free?
What you have to keep in mind is that there are no debts that don’t have any risks. Yes, even good debts can become bad eventually when the circumstances line up just right. For example, a master’s degree cannot guarantee a high-paying job. An economic crisis can cause your business to fail.
Thus, when you take on a loan or debt, make sure to account for worst-case scenarios. If you have a business, don’t just assume that you have to get an SME loan ASAP. Check your cash flow and see if you’re making enough revenue to justify taking out a loan. If not, you may want to improve on certain aspects of your business first.
The same can be said when you take out a home loan. If you have high mortgage payments that take a significant chunk out of your income and make it difficult for you to pay for your other expenses, then that’s bad debt. The key here is to not regard every kind of loan or debt as inherently bad. Rather, you should take into account various factors that can affect your capability to pay off that debt. You should also be mindful of the purpose of the debt; if it can result in your financial health and stability, then go ahead and take out a loan!