As you know, credit history demonstrates whether you can purchase high-priced items like a house or a car or not. This concept is based on your debts, your responsibility, and your ability to repay them, and that’s why having debt is not as frightening as you think.
Debts are financial tools to help people or businesses kick start what they have planned or keep their plans going. Read more about loans here.
Although, it’s vital to note that debts have two main categories, good and bad debts. In this article, financial experts at YounGo have decided to discuss these two important concept in a simple way for kids to understand.
In a nutshell, good debt is the money you borrow to build wealth, and bad debts are the opposite, which doesn’t increase your income.
Kids need to be able to distinguish between these two concepts when learning about financial literacy.
Factors that Show a Debt is Good or Bad
- Wants and Needs: Perhaps this factor has the most significant impact on debt, being good or bad. As you know, needs are the things and items people “should” have in their lives in order to survive, and improves their quality of life, such as food, clothes, etc. On the other hand, wants are what people desire to have, but having them is not necessary for their lives, such as a brand new mobile phone, designer clothes, etc.
- The Value of What You Purchase: You should be aware that you’ll have a bad debt if you use it to buy items that lose their value over time, like borrowing money to buy cars or clothes.
- Repaying: It’s obvious that if you can’t make the payments, the debt is bad, and that’s exactly what your kids need to learn.
- The Rate of Interest: It’s another vital factor that you should take into account if the rate is very high and you need to pay much more than you borrowed, this is what we call bad debt.
What is Bad Debt? Definition and Examples
As we mentioned in the introduction, bad debt is borrowing money to buy depreciated items that don’t improve your income or generate money. Bad debt can damage your net worth and usually have a high-interest rate. That’s why it’s crucial to consider some factors before going into debt or to determine whether a debt is good or bad.
It’s a general rule that you can’t make money out of bad debts, and you also can’t afford to repay them.
Examples of Bad Debt
Let’s take a look at some debts that are considered bad, and see the reasons why they are in this category.
No one is unfamiliar with this bad debt as it seems to be the most common bad debt. As you know, various lenders issue credit cards and let you make purchases using your credit. They often have a very high, and it may easily get out of control. Although, it doesn’t mean that it’s bad to have credit cards as they can be a great help when you are facing a financial crisis. All you need here is to have better strategies for using your credit cards.
Dissimilar to a house, the value of cards decreases over time and that’s why car loans fall under the category of bad debt.
Because of this reason, it’s vital for car owners to know when to sell or trade their cars.
Many factors like mileage, the number of owners it had, the length of the warranty, etc., can be the reasons a car depreciates, and that’s what makes all your interest payments in vain.
The financial experts suggest paying as much you can in advance as it lowers the interest rate.
Similar to credit cards, personal loans can get out of hand easily and quickly. However, the thing you use the loan for determines whether a loan is good or bad.
The interest rate of a personal loan depends on your credit and it can be used for many reasons such as making an investment, travelling, emergencies, purchasing expensive items, etc.
Good Debt, Definition and Examples
To put it in simple words, a good debt improves the value in your life, such as increasing your net worth or generating more income for you.
Good debt is like making an investment that will financially put you in a better position. In contrast to bad debts, what you purchase using good debts won’t go down in value.
According to the factors we’ve mentioned earlier, getting a loan to pay for education is a perfect example of good debt. Despite the high price of going to school, graduated students are more likely to find jobs with higher pay.
Why are student loans considered good debt?
- Their interest rate is usually lower than other loans
- Most of these loans come with various repayment plans and methods
If you take out a mortgage to buy a house, you can be happy as you are not stuck in bad debt.
The value of a house can remain still or increase over time. As a result, it can cover your loan repayments.
Please note that your mortgage can turn into bad debt. To prevent that from happening, be sure to make the payments on time and look after your property.
Read more about mortgage loans here.
Good Debt vs. Bad Debt
Now that you know all the details about good debts and bad debts and how to recognize them, you need to ask yourself the £1 million question: how does this debt change your life?!
In order for your kids to make better financial decisions, they need to learn these concepts and basics as soon as possible. Parents should also make sure that they know the difference between wants and need and can decide what to save up their pocket money for.