What is good and bad debt? How to tackle debt?
In this blog, we will understand what is good and bad debt. Also we will take a look at ways one can handle it, in a traditional finance as well as behavioral finance approach.
Good Debt vs Bad debt
- Good debt is basically a debt that helps to create assets which generate income in future and also build a credit history.
- A good debt will create value for the borrower in a longer term. Usually if the return on investment for an asset purchased by taking a debt is greater than the interest rate on loan, it is considered a good debt.
- Let us understand this with the help of an example. Say, a person takes home loans at 8% p.a. It can be considered as a good debt because:
- He can claim tax deductions on the same loan under section 80C and 24C.
- If he falls under tax bracket of 30%, his effective cost of debt comes to (8*(1-0.3)) 5.6%
- Now,if the asset(house) appreciates at a rate greater than 5.6%, it will create a value for the person taking loan.
- Bad debt, on the other hand, is a loan which will lead to misallocating the resources to unproductive expenses. Whenever a loan is taken to invest in depreciating assets that are not necessary, it is termed as a bad debt.
- Bad debts tend to reduce the overall net worth in the future. This is because it sabotages the future cashflows by hefty interest payments.
List of Good and Bad Debts from personal finance perspective
Examples of good loans where borrower can claim tax deductions and decrease the effective interest rates as well as build a credit history are:
- Home Loan
- Education Loan
- Credit Card dues – This is a very high interest rate loan which does not yield any further cash flow. Once a borrower gets used to credit cards , he/she gets stuck in the vicious cycle of over spending which ultimately disturbs his/her financial planning.
- Personal loan/ unsecured lending – These loans also have quite high interest rate of 14-15% p.a and are not tax deductible.
- Vehicle Loan – Vehicle, if it is a necessity then cannot be considered as a bad loan. However,if a person has some extra money, which is currently invested in low yielding investment as well as a car loan, it is preferable to withdraw that extra money and pay off the car loan.
- Loan against Property/Security – The interest on these loans are not tax deductible and involves a risk of losing the property which is mortgaged.
How to tackle debt?
- Make a list of loans in descending order i.e loan having highest interest rate starting first.
- As soon as you have enough liquidity , start paying off the loans. Start with bad debts like credit card dues, etc first.
- With respect to good debts, one can have two options
- According to traditional finance theory, if a debt has lower effective interest rate, it is advisable not to undertake prepayment of loans. Instead the extra liquidity/cash that is to be used in prepayment can be employed in lucrative investment options.
- However, behavioral finance theory gives more importance to peace of mind rather than number crunching and calculations. So taking into consideration one’s risk profile and overall perception of risks, if one feels that even a good debt is beyond their risk profile and taking a toll on peace of mind, one can go for prepayment.