Part 1: The difference between good and bad debt

For many South Africans their relationship with debt has been a toxic one dictated by hounding creditors, missed payments, and potentially expensive interest rates.

This is reflected by nearly half of credit-active consumers in South Africa having impaired credit records as a result of mismanagement of debt, says the National Credit Regulator (NCR).

But debt isn’t all bad – there’s good debt to be made too.

In the first part of our Debt-ucate series we explore the difference between good and bad debt and why debt is, in fact, necessary.

Tip: If you’re struggling with debt and need assistance in managing it, click here.

Whether it’s student loan debt, buying your first vehicle, or something as small as purchasing a cell phone on credit, very early on in one’s adult life you’re often forced to incur some or other debt.

This is also encouraged because building a sound credit record becomes important when wanting to qualify for larger credit such as a home loan later in life.

“Young earning individuals are often pressured into building a credit record but aren’t given the information or tools on how to do so responsibly. They’re told to make debt but don’t understand what that means or what kind of debt they should be looking into,” says an Absa in-branch consultant.

Therefore, it’s important that you understand both sides of the coin – taking out debt and paying it off.

What is bad debt?

Bad debt is something that income-earning South Africans are all too familiar with. This is debt accrued on non-essential items that quickly lose their value, do nothing to generate long-term income, and carry high interest rates, such as credit card debt.

Short-term debt is the largest contributing factor to bad debt. This is typically offered by non-bank institutions, trapping desperate consumers with low qualifying criteria and later hitting them with expensive instalments.

These consumers are then often unable to manage payments, to which they respond by taking out further credit to service their current debt. Needless to say, this is not financially sustainable and typically leads to consumers becoming overindebted.

“The debt cycle in South Africa is terrifying,” notes DebtBusters, a leading South African debt counselling company. “This is reflected by clients who are increasingly under tremendous financial strain.

“Some of these consumers are using 64% of their net income to service their debt monthly.

“It’s clear that in the absence of real income growth, consumers are supplementing their income with unsecured lending on a large scale,” DebtBusters says.

Some examples of bad debt include:

• Credit card debt. One of the quickest ways to build a credit record, credit card debt is often racked up by consumers as a result of high interest rates. If mismanaged, this can lead to becoming overindebted.
• Personal loans. This the most common form of short-term debt. The inflated interest rates that these loans attract are based on your credit record and score. They’re payable in instalments and last from two to five years.
• Vehicle loans. While this loan type is often unavoidable, vehicles tend to depreciate in value over time. This makes interest payments all the more pointless over the five to seven years these loans take to repay.
• Pay day loans. These short-term loans are notorious for attracting extremely high service fees and interest rates. The entire amount is typically payable by the next pay day – an impossible task for most consumers desperate enough to take this type of loan.

The general rule of thumb to avoiding these debt types is, if you can't afford it, and you don't need it, don't buy it. What’s also important to note is that these bad debt examples don’t always have to translate to over-indebtedness.

The Absa consultant notes, “While certain types of debt definitely have a bigger chance of negatively affecting your finances, it is up to you to manage your debt responsibilities.”

Should you be unable to do so, it’s both your right and responsibility to get reputable help.

Good debt, and why it’s necessary

Good debt is any loan that is potentially beneficial to your financial health, meaning it generates income, or assists in adding long-term value to your life and future.

“Good debts can be seen as investments towards your future. It’s the kind of debt you want to take on,” says the Absa consultant.

Good debt is obtained by making wise long-term decisions, not for the sole purpose of having good debt. For example, you might make a decision to obtain a master’s degree to increase your earning potential. Taking out a student loan, if you have no other way of financing your education, is a valid reason for going into debt.

Examples of good debt include:

• Mortgage loans. Since property and houses usually appreciate in value and provide you with an asset you can use to generate income, a mortgage loan is considered an investment.
• Student loans. This type of loan allows you to further your education and better your career opportunities and income. This is seen as an investment in your financial future.
• Business loans. This is typically taken out to start or further a business. If your business succeeds and generates income, this is considered an investment.

Even though certain debt types are considered worthwhile, it’s important to ensure that the debt you do take on is affordable and well managed.

To understand how you can lighten your debt load and pay less while servicing all your debt, click here.