Debt can be daunting. Watching a portion of your hard-earned paycheck vanish towards loan payments can be disheartening. However, not all debt is created equal. In fact, certain types of debt can be advantageous under the right circumstances. Understanding this distinction is important for your financial skillset.
In this article we’ll walk through what good debt is and the most common ways you can do it.
What is good debt?
Good debt is the concept where you borrow to invest in an activity that will make you better off in the long run. In other words, you get a loan now to improve your financial position in the future. Good debt will create wealth. In contrast, bad debt is when you borrow money to purchase a depreciating asset. The asset in question will not generate wealth in the future and will instead lose value. This is what differentiates a debt that is “bad” to one that is “good”.
Examples of bad debt could be borrowing for:
- Cars, which continue to depreciate in value
- Consumables like clothes and food, leading to high credit card debt
Bad debts generally have higher interest rates than other types of finance. As a result, short-term debt can become long-term and continue to minimise your wealth. Accordingly, if you’re planning on borrowing money it’s important to consider whether it will positively or negatively impact your finances.
What are some ways I can engage with good debt?
There are three main examples of good debt:
- Paying for education
- Investing in a small business
- Purchasing real estate
The general principle is that the more educated you are, the greater earning potential you have. A recent 2020 publication by the Ministry of Education found that having a degree or higher-level education results in higher annual earnings and potential. Nine years after leaving school, those with tertiary qualifications were expected to earn 15-20% more than someone who only obtained UE and 40-50% more than someone who finished with NCEA Level 2.
Furthermore, higher education positively impacts your likelihood of finding a job. Generally, the higher educated you are the more the unemployment rate decreases. The current unemployment rates in New Zealand reported by StatsNZ are lowest for those who attained post-secondary school education.
These two features make your education a viable thing to invest in. Since most tertiary education in New Zealand is funded by student loan, this makes it an example of good debt. Once entering the workforce and earning money, it becomes easier to repay your student loan. However, it’s important to note that your salary can vary depending on what field you studied at university. If you’re thinking of going into further education, consider how much your profession makes and how important the work is to you. You can get a sense of where the most money is by looking at the highest-paying jobs in New Zealand.
Taking out a loan to help start up your own business can also be considered as good debt. Similar to education, financing your business with borrowed funds comes with its own share of risks. If the business struggles in its early period, the added strain of interest payments can affect the business’ success. Thus, start-up loans can be costly. Furthermore, most typical business loans have strict eligibility and require a satisfactory credit score.
However, a successful business has the potential to continue growing in value and income. The debt would then be worth it. Business start-up loans come with their share of benefits as well. Things like leases, permits, equipment and shop fittings are all costs associated with starting a business. Having the capital on-hand from a business loan can therefore be useful to help cover these costs and get your business off the ground. Because the debt can be used to invest in the business to generate an eventual return, borrowing for a start-up can be another example of good debt.
A home or property can be considered as an appreciating asset. Although it’s seen some volatility in the last few years, homes in New Zealand have historically seen consistent increase in value. We can see this in the median house prices from 1992 and the average house price since July 2018. Accordingly, taking out a mortgage to purchase a home (an appreciating asset) would be an example of taking on debt to generate wealth in the long-term. Mortgage payments continue to build home equity. Moreover, the capacity to generate further income through renting it out helps as well.
If you’re looking at buying a house soon, consider the range of mortgage options you have available here.
In summary, in this article we discussed:
- The difference between good and bad debt
- The three main methods of taking on good debt, including:
- Real estate
While debt is a constant in our financial lives, it’s not all bad. Consider using debt strategically to overcome short-term obstacles and secure lasting gains.
If you’re looking for some help financing your next big move, a personal loan from Pioneer Finance can help. Get in touch with the team and we’d love to discuss what finance options are right for you.