Debt is an important part of the financial cycle but it can also be a source of distress for many individuals, whose incomes get swallowed up by repayments. According to data from the Census and Economic Information Center (CEIC), Kenya domestic credit reached USD 38.9 bn in January 2021, an indication that we are borrowing more and more. However, debt is not inherently bad. Did you know that there can be good and bad debt?
Good debt is defined as any amount you borrow, which will generate an income or help you increase your net worth. Examples of good debt include:
- Borrowing to advance your education
As a general rule, the higher the level of education you are able to reach, the higher your earning potential becomes. Therefore, an investment in your own education can offer you great returns. Taking on debt to pay for school can be a good idea because once you start earning as a result of your education, you will be able to repay your debt and grow your wealth gradually.
It is, however, crucial that you choose wisely what to study. Not all fields of study lead to lucrative careers.
- Borrowing to start a business
You’ve heard the saying, “it takes money to make money.” What if you have a promising business idea and none of the funds to actualise it? One option is to take a business loan and repay it from your profits. Nevertheless, be aware of the fact that many startups fail, and the loan should not be your only source of business funding. You also have greater chances of success if you start a business in a field you know in depth and are passionate about.
- Borrowing to buy a home
Land and property can be a good investment and has the potential to earn you a return. It also qualifies you for exemptions, which reduce your overall tax burden. In addition, it can be an avenue for you to earn a regular rental income.
Bad debt, on the other hand, is money borrowed for consumption or other use that does not create value. Once this money is spent, there is no way to recover it. Examples of bad debt include:
Most of the digital loans taken by Kenyans are for consumables. Usually, this includes basic needs like rent, food and transportation. The problem with borrowing to cover your essentials is that it is very expensive. Remember, you will have to repay much more than you received. On top of this, once that money has been spent, it is gone, yet your expenses will still remain, and so will your debt. It is recommended that you exhaust all other sources before taking a loan to cover your needs.
You may think of owning a car as a basic need. However, from a financial point of view, taking a car loan is a bad debt. A car will begin to depreciate immediately you drive it off the lot. If you must have one, look for car loans with little or no interest, so that even if the asset is depreciating, you do not have to worry about interest on top of it.
In conclusion, the line between good and bad debt is easily distinguishable. Before borrowing, ask yourself, “will this debt pay me back more than it has cost me?” Consider factors such as the interest, terms of repayment, penalties for defaulting, and loan charges before taking any debt. Moreover, regardless of whether you consider the debt good or bad, you should have alternative repayment plans in case the primary one does not work out. Ultimately, debt can be useful, helping you achieve your goals in the absence of other sources of money. However, care must always be exercised to prevent drowning in debt.