In the world of personal finance, the words "debt" and "good" rarely appear in the same sentence. However, there is a crucial distinction to be made between good debt and bad debt, and understanding this difference is the first step towards financial empowerment. That way you can use debt as a financial tool to achieve your goals rather than making it a burden on your finances.
What is the difference between good debt and bad debt?
In one of our Pinoy Money Master episodes, Gen-Xer Melissa Tongol, a businesswoman by profession and one of our contestants, dished out some solid financial advice.
Good debts are considered investments in your future
The notion of good debt may seem counterintuitive, but it refers to borrowing for investments that can yield long-term benefits. Here are a few examples:
Taking out a student loan to finance your education can be seen as an investment in your future. Education often leads to better career opportunities and higher earning potential, making it a worthwhile expense that will benefit you over the long term.
A mortgage is a classic example of good debt. It allows you to purchase a home, which, over time, typically appreciates in value. In addition to homeownership, it can also provide financial stability and tax benefits.
Entrepreneurs often require loans to start or expand their businesses. When used wisely, these loans can contribute to business growth, leading to higher profits and financial success.
Investing in income-generating real estate properties can be considered good debt. The rental income can cover the debt payments, and the property may appreciate, offering a long-term return on your investment.
Bad debts are a drain on your finances
Bad debt refers to money borrowed for non-essential or depreciating assets. Here are a few common examples:
Credit card debt
Using credit cards to finance everyday expenses or luxury items without paying off the balance in full each month can lead to high-interest payments and accumulated debt.
Loans with exorbitant interest rates, such as payday loans, can quickly become bad debt due to their high cost.
While a car loan may be necessary for many people, borrowing too much for a rapidly depreciating asset can strain your finances.
Financing non-essential items like electronics, vacations, or clothing through loans can result in bad debt since these items do not appreciate in value.
How to manage debts in a way that promotes financial well-being
Now that we've distinguished good debt from bad debt, let's discuss how we can actively take control of our finances.
Create a Budget
Start by understanding your financial situation. Create a budget that outlines your income, expenses, and how much you can allocate to debt repayment. This simple step gives you control over your finances.
Prioritize high-interest debt
If you have high-interest debts, such as credit card balances, tackle those first. The interest on these debts can add up quickly and be a significant financial burden.
Develop a debt repayment plan
Organize your debts and establish a repayment plan. Consider using strategies like the debt snowball (paying off smaller debts first) or the debt avalanche (tackling higher-interest debts first) to systematically pay down your obligations.
Build an emergency fund
Having an emergency fund can prevent you from relying on high-interest credit when unexpected expenses arise. Aim to save three to six months' worth of living expenses.
Seek professional guidance
If you're overwhelmed by debt, don't hesitate to seek the help of a financial advisor or credit counselor. They can provide guidance on managing your financial situation effectively.
Avoid new bad debts
After paying off bad debts, focus on maintaining your financial health. Build a financial buffer like investing in assets that appreciate over time, or investment-linked life insurance that gives you insurance coverage while helping you grow your wealth over time. Knowing that there is financial protection in place in case of emergencies or unforeseen events will allow you to navigate daily life with greater confidence and peace of mind while building your investment portfolio at the same time.
Need help taking control of your finances?
Debt doesn't have to be a burden; it can be a tool for achieving your financial goals when used wisely. Remember that financial education and discipline are your allies in this journey. Your financial future is bright, and by managing your debt positively, you're taking the first step towards taking control of your finances and achieving your financial goal.
If you need help in better managing your finances or working on your financial security, check out Manifest, our investment-linked insurance that gives you life coverage while providing investment opportunities without you having the need to manage it yourself.