Whether it be borrowing a dollar from a friend to buy a soft drink at school or obtaining a mortgage to purchase your first home, owing money or going into debt is a fact of life. For some people, having outstanding debts can be difficult to manage and affects how they deal with their other financial matters. One of the practical approaches to managing debt is identifying what type of debt that you have incurred. Debt can be classified as either good debt or bad debt in which you should have a plan to repay the money.
This article is divided in two sections. The first section lists a number of scenarios in which you have to decide whether the individual is going into good or bad debt. The second section provides the substantiated answers. (Be sure to have a pen handy to write down your answers beside each of the scenarios).
1. Bernard has a date with a classmate in which wants to impress her with a fashionable blazer. Aside from his tutoring sessions which he earns $50 per week, he does not have a stable job. Bernard decided to buy the blazer for $300 at a high end department store using the credit card program. Has Bernard incurred good debt or bad debt?
2. John-Francis is a deejay that performs regularly at private parties with his own equipment. He earns $450 per party that he agrees to play. He also has been booked for the next three Saturday nights. While testing his sound system before playing at the first wedding, he discovers that both his speakers are blown out and quickly goes to a store specializing in audio systems. He charges $850 to his credit card to buy the speakers knowing that he has only $100 in cash in the bank. Has John-Francois incurred good debt or bad debt?
3. Paulina wants to buy a car to get to work. She is fed up with relying on buses and metros that does not show up on time for her schedule needs. Through her circle of friends, she hears about a deal on a second-hand car and buys it “as is” without a car inspection. She pays for the car thanks to a personal loan of $800 that she had to fight for at the bank because her credit rating is not that great due to past credit card charges she made during her academic career. Has Paulina incurred good debt or bad debt?
4. Jack has just graduated from law school from Vancouver and is looking to live in downtown Montreal where he wants to close to the office of the law firm that hired him. The law firm has hired him based on his knowledge of an industry that shows huge opportunities for legal services for the next 15 to 20 years. Jack selected to buy a condominium on the outskirts of downtown for $300,000 by obtaining a $285,000 fixed mortgage at 3.5% for 5 years. Has Jack incurred good debt or bad debt?
1. Bad Debt. Although the blazer can be used again, the main reason for the purchase does not warrant spending the $300 that Bernard does not have in the bank. Unless Bernard uses his savings to pay his bill in full, he will be stuck with interest charges at the department store’s rates in which they are usually higher than major credit card companies.
2. Good Debt. Even though John-Francis only has $100 in his bank account at the time of the purchase, he will have $900 (from the two booked weddings) when he receives the bill in the mail and the equipment that can be used to generate income in the future.
3. Bad Debt. Paulina is taking a risk of using a personal loan to pay for a car that has not been examined for potential problems. At any time, problems could occur in which Paulina has to pay for repairs and at the same time of repaying the bank $800 plus interest.
4. Good Debt. Under the assumption that Jack remains at the law firm and gets promoted with a pay raise, buying the condo is an investment that maybe costly in the first couple of years, however; it may be profitable in the long run if the interest rates remains low.
The scenarios and answers highlighted in this article have drawn a clear distinction between good debt and bad debt. Good debt is worth incurring if it is linked to a long term investment and bad debt can be seen in purchases that cannot be afforded or leads to interest payments.
To learn more about Good Debt Versus Bad Debt, watch the following video.