Debt has long been a taboo for most Indians, although attitudes are changing rapidly. Now, there is a more structured thought process on debt; which classifies debt into good debt and bad debt. The latter is, apparently, responsible for people getting into debt stress and debt traps. That is because bad debt tends to be high-cost and does not create anything productive; tangible or intangible. Bad debt is the high-cost debt you use to fund your lifestyle spending.
Good debt vs bad debt: The dividing line between good and bad debt is quite thin. However, there are some simple rules that can be used. For instance, any debt that helps create tangible assets for the future or helps create intangible skills for the future or helps reduce your debt burden is good debt. On the other hand, debt that increases your debt-to-income ratio, or adds to your high-cost debt or is used for buying creature comforts and conspicuous consumption needs; will classify as bad debt.
If you look at it the other way, good debt adds to your positive net worth in the medium to long run. For example, a mortgage loan to buy a property can improve your financial net worth because it reduces your rent expenses and also creates an appreciating asset like a home in your personal balance sheet. These advantages can legitimately add to your net wealth in the long run. Another example is borrowing a loan against your gold holdings and using the low-cost funds to repay your high-cost debt. The gold is still yours as long as you are paying interest on time, and it is an appreciating asset.
On the other hand, reducing your high-cost loan adds to your net worth by cutting debt to income ratio. The two questions you need to ask yourself to identify good debt is; Will the debt help create assets to enhance net worth, and will the debt help me reduce the ratio of debt servicing to income. If the answer to either is ‘yes’, you are looking at good debt.
What are some examples of good debt?
Even at the risk of sounding hackneyed, we must underline that good debt must meet at least one of the two conditions. It must either help to create assets that will enhance your net worth in the medium to long run; or reduce your debt service to income ratio. Here are some illustrations. Mortgage loans to own a house is an example of good debt. There are several benefits. In India, property has been an appreciating asset over the medium to long run. In addition, the cost of funding is quite low and it reduces further if we consider tax benefits of taken a home loan under Section 24 of Income Tax Act.
Business loan taken to expand your growing business is another example of good debt. Here, you are betting that the business would eventually grow and generate more revenue. Also, the interest on the debt can give you a tax shield, so it is all the more productive.
What about an education loan to create intangible assets; like an advanced degree in artificial intelligence (AI) or machine learning (ML). Obviously, AI and ML are likely to change the face of business. That means; it is a boost to your career and income earning capacity in the long run. Also, education loans are low-cost and have tax shields under Section 80E.
Finally, there are loans that enhance value by reducing your cost to income ratio. If you are stuck with high-cost debt, leverage your assets. Use your gold, property, shares to get a secured low-cost loan and reduce your high cost debt. It helps reduce your debt service to income ratio. That is the crux of the story. Good debt either creates valuable asset, builds a valuable skill, or reduces the loan service to income ratio for you.
Is everything else bad debt?
Taking on debt you cannot afford is bad debt. Similarly, taking on debt to buy consumer goods you do not really need is also bad debt. If your lifestyle and debt management is pushing you deeper into a debt morass, that is bad debt too. Here is how bad debt looks like. Taking a loan to buy a utility car to save on time and travel costs is an acceptable debt. However, emptying your purse to buy a fancy luxury car is outrageous. That is bad debt. You surely, need to spend on consumer goods. It is not just about peer pressure, but also about what the family needs. But taking a high cost consumer loan to buy an 80-inch UHD TV to watch IPL is nothing short of inane.
Finally, flashing your credit card like your debit card is also bad debt, especially considering that it costs over 40% per annum and if you are going to keep rolling the debt by paying just 5%.
The distinction between good debt and bad debt is about the level of prudence. Debt is not anathema; it is when you treat debt casually that bad debt problem starts.
Nehal Mota is co-founder and CEO, Finnovate.