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Good versus bad debt

By Christeen Haddadin - Sep 05,2021 - Last updated at Sep 05,2021

Photo courtesy of Family Flavours magazine

By Christeen Haddadin
Certified Money Coach

 

You must be feeling the pressure if you are juggling three to four loans between mortgage, personal loans, car loans and credit cards with monthly payments that accumulate to 30 to 40 per cent of your net income. 

Are you feeling a strain on your cash flows, your spending, your emotional and mental health? Do you feel like even though you are meeting the monthly payments on your credit card, the balance doesn’t seem to budge?

 

Good debt

 

Good debt can help you build your net worth, meaning loans that help you acquire assets like a mortgage. Buying property can make you money in two ways: lease it or capitalise on its market value appreciation. Good loans help you build skill or acquire knowledge that will eventually increase your earning power, such as student loans or personal loans for courses and certifications.

Although loans that build net worth and increase earning power are categorised as good loans, this does not mean we should walk into them blindly. A decision concerning debt needs to be made with a certain degree of financial awareness and literacy to ensure the debt is structured and managed properly.

 

Bad debt

 

Bad debt are consumer loans such as credit cards. It is so easy to indulge in impulsive buying when credit is so accessible and the minimum monthly payments are not high. The credit balance accumulates quickly until you hit your credit card ceiling of, say JD2,000. Continuing to pay the minimum monthly payment (JD60 and declining as debt balance declines) would take you 139 months to full repayment while paying a total interest of JD1,700! 

Accumulating expensive debt could cost you thousands of dinars in interest and tens of years of debt. And if the debt does not build assets, the debt will eat into your net worth and you could end up with a negative net worth (with higher debts than assets). 

Car loans are also categorised as bad debt. Although you are buying an asset with this debt, this asset depreciates in value over time.

Bad debt can also accumulate due to lack of an emergency fund when faced with an unexpected event or obligation such as an accident or an emergency plumbing situation. When we do not have a financial cushion to fall back on, it becomes inevitable to resort to debt. Building an emergency fund can prevent burdening yourself with debt.

 

Debt prevention tips

 

Saving for specific goals like travelling would help you achieve your plans without tapping into credit lines. Another debt prevention mechanism is to diversify your income sources – consider generating secondary income from a side hustle or negative income from an investment portfolio.

Repaying debt frees up a portion of your income, allowing you to build your asset base and grow your financial net worth. I would encourage you to explore and research debt repayment strategies such as the Snowball Method or Debt Avalanche to help you repay your debt faster while paying less interest. And I would invite you to explore online debt calculators to build scenarios for different debt repayment strategies so you can get a sense of the amount of interest you could save to motivate your commitment to a debt repayment strategy.

A Useful credit card tip: paying more than the min monthly payment on your credit balance could save you thousands of JDs in interest and save you years on the loan’s life.

Back to the example above, if you increase your monthly payment to a fixed monthly payment of JD70, you would pay a total interest of JD630 and be debt-free in 38 months. Paying above the minimum balance would save you JD1,070 in interest and repay the debt eight years sooner.

 

Reprinted with permission from Family Flavours magazine

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