People often think of debt in simplistic terms. ‘Good debt’ improves your financial position, and ‘bad debt’ pays for things you don’t need and that quickly lose value.
The problem with this perception is that it ignores the reality that borrowing decisions are often more nuanced than simple labels suggest.
“Debt is not inherently good or bad,” explains Shafiek Ho-Kim, Growth Head at DirectAxis. “Typically, people consider credit to be good when it creates or preserves value and bad when it’s used for discretionary spending. This isn’t always the case.”
On the surface, borrowing to buy an asset that will appreciate over time or improve your earning potential is a sensible decision. Examples include a home loan, a loan for home improvements such as solar panels to reduce electricity costs or borrowing to further your education.
But just because a loan can potentially improve your situation, it doesn’t mean the debt will automatically be affordable. When repayments mean you struggle to meet your monthly commitments, what may seem like a good investment could actually cause financial problems.
Ho-Kim says before you commit to a loan, consider the total cost of credit, including any fees, insurance, interest and the term or duration of the contract.
“A longer-term loan may have a lower monthly repayment but cost more overall, especially on the interest. A loan with a higher monthly repayment and shorter term may cost less but could add financial pressure if it’s not managed effectively.”
He explains that even if you can afford the monthly repayments, you should allow yourself some breathing room.
“Don’t just consider whether you can afford the new loan; look at your total debt burden and whether the combined repayments will leave you with enough disposable income each month. Also think about what happens if there’s an unexpected expense or emergency. Will you still be able to make the repayments?”
Another common assumption is that all consumer debt is ‘bad debt’.
Borrowing for a necessary or unexpected expense, such as replacing a broken appliance or paying for a car repair, can be a rational financial decision. A personal loan may provide a structured, manageable way to pay, rather than using more expensive or unpredictable forms of credit.
Ho-Kim says that borrowing becomes problematic when it’s used to repay other debt. Repeatedly borrowing to cover existing repayments or everyday expenses without addressing the underlying cash-flow issue can lead to a debt spiral that ultimately becomes unsustainable.
It is important to distinguish this type of borrowing from debt consolidation or refinancing, which combines various debts into a single loan. This can simplify repayments, making them easier to manage and may reduce the total cost of servicing several debts.
Ho-Kim suggests considering the following questions before borrowing:
Is it productive? Is it likely to create value, reduce future costs or improve your financial position? If so, are the payments affordable?
Is it manageable? Is it a legitimate expense where you understand the total cost of the loan, can comfortably make the repayments and have some financial wiggle room if something unexpected happens?
Are you just postponing the problem? Are you borrowing to get short-term financial relief rather than addressing the underlying affordability issue?
“Credit is more complex than the simple labels we sometimes use to define it. When it is used deliberately and responsibly, it is a useful financial tool,” Ho-Kim concludes.
