Responsible borrowing: the difference between good and bad debt

Responsible borrowing: Canstar explores the difference between good and bad debt, and how credit cards fit into the equation.

There’s a time to borrow and there’s a time to save. You might recognise this line. It’s one straight from the script of a TV advertisement for a Kiwi lender that offers unsecured personal loans.

In many respects, it’s a truthful adage. People have always borrowed money. Governments have always borrowed money. Used wisely, debt can be a tool to fund personal growth and fund life’s major milestones, such as going to university or buying a home. Debt is integral to our economy. However, if misused rashly for short-term gratification, not only can it cost you dearly, it can become a millstone that weighs negatively upon your long-term financial health. This is the difference between good and bad debt.

What is the difference between good and bad debt?

Not all debt is created equal, some loans are more useful and less costly than others. A great example of a good loan is debt incurred to pay for education.

If you’re a recent graduate with a big student loan, your debt might not give you a fuzzy warm feeling (read here for tips on paying it off faster). But given that loans are interest-free for those residing in NZ, their cost will diminish in time – thanks to the eroding power of inflation – and, ultimately, pay dividends through greater job opportunities and earnings.

Borrowing money to expand a business is another example of good debt, if it leads to increased sales and revenue. Likewise, taking out a loan to buy a home. Very few people have enough cash to purchase a home outright, that’s where mortgages come in. Over the term of the loan, despite today’s low interest rates, you’ll pay a lot of interest but, hopefully, this will be offset by the steady creep in house prices.

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If you’re borrowing to invest in an asset that has the possibility to increase in value, then you’re looking at good debt. Bad debt, is the opposite, and for just the kind of purchases highlighted in many adverts for payday and other unsecured lenders.

Bad debt funds needless extravagances: foreign travel, electronic gadgets, retail therapy binges, nights out and entertainment. If you’re racking up debt to fund lifestyle choices, then the money-savvy option is to change your lifestyle to one that’s more affordable.

Of course, there are times when you might need to take out a personal loan, to cover an unforeseen event – for example, when your car suddenly dies on you. When this happens, it pays to shop around and do your homework. Ask yourself some basic questions:

  • How much will you have to pay each month?
  • How much of your income will that represent?
  • How long will it take for you to pay back the loan?
  • What are the terms of the loan?
  • Is there a cheaper option available?
  • How much debt do you have already, and is it worth loan consolidation?

Compare personal loans with Canstar

Credit cards: good debt or bad debt?

Used properly, credit cards are a perfect example of good debt. They offer a revolving line of credit and – if you choose the right card to meet your spending and pay off your balance each month – they should either cost you nothing or, even better, earn you cash or rewards!

According to Reserve Bank of NZ statistics, we spent $4.1 billion last December on our plastic – 25% more than five years ago. But a lot of us are not paying off our credit card debts, as the same amount is currently outstanding, earning the card providers a tidy amount of interest.

To ensure your credit card use ticks all the right boxes, make sure you understand how your card’s interest-free days work and pay off your spending in full each month to avoid interest charges. Also, pick a card that suits your spending.

Rewards – from cash to goodies and flights – come at a cost and, if you don’t meet minimum annual spend requirements, you could be better off opting for a card with a low fee or interest rate, instead.

Compare credit cards with Canstar

For example, if a Classic cash-back reward card returns $1 for every $150 spent, with a yearly fee of $40, you’ll need to spend $6000 to break even.

For a $90 annual fee, a Platinum card will offer a better cash-back rate: $1 for every $90 spent, but you’ll need to spend $8100 to cover the cost of the fee.

Do the sums and you’ll find that because of the Platinum card’s increased return, if you spend $24,000 over a year, you’ll pocket $176 after paying the annual fee, compared to $120 for the Classic. That’s a 46% difference, which will keep widening the more you buy. Spend $60,000 on the Platinum card and you’ll earn $666 in total (before fees), compared to $400 on the Classic card.

With flight rewards, the same spend-to-reward ratios apply. In Canstar’s latest credit card research, we discovered that flight rewards cards’ returns are linked to expenditure, performing better with top-level spending over $24,000 per year. So it’s important to choose the right card to match your spending patterns.

While debt has many negative connotations, choosing the right loans and credit cards to suit your needs does not have to be difficult. With the help of Canstar’s free tools and advice, you can get a clearer picture of the right financial products to suit your needs, and make more informed decisions about your personal financial goals.

Compare credit cards with Canstar

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