Debt can be a double-edged sword in your financial life. When managed wisely, it can be a valuable tool that helps you achieve your goals, whether it's buying a home, starting a business, or pursuing higher education. However, when not handled with care, it can turn into a financial nightmare, leading to a debt trap that is difficult to escape. It’s essential to understand the difference between the two types, as well as how important it is to empower yourself with financial literacy before making major financial decisions.
Understanding Good Debt vs. Bad Debt
To effectively avoid bad debt, it's crucial to understand the distinction between good debt and bad debt. Good debt is typically associated with investments that can appreciate (increase in value) over time or increase your earning potential. Good examples of good debt include a loan to buy a home, a student loan to invest in education, or a business loan to start or expand a business. These debts have the potential to generate long-term returns or increase your earning capacity.
Bad debt, on the other hand, involves borrowing for non-essential, depreciating (decreasing in value), or consumable items, like groceries or new sneakers. Using your credit card to buy consumables is one of the most common examples of bad debt, because of its high interest rates, low minimum payments, and the fact that it is often used for spending on items you don’t need, like clothes or holidays. These purchases don’t typically give you any long-term value or income.
Our Operations Associate Keval Maharaj offered a tip on how to avoid bad debt: “To avoid irrational and impulsive spending, set aside an amount you can afford monthly for ‘luxury’ items. By allocating a specific amount for indulgences, you can satisfy your desires without jeopardizing your financial health. This approach not only helps you avoid irrational spending, but also reinforces the discipline you need to maintain a balanced budget.”
Tips to help you stay away from bad debt
1. Create a Budget
To establish a strong financial foundation, it's crucial that you have a budget. This involves tracking your income and expenses, allocating your resources wisely, and setting aside funds for savings, investments, and necessary expenditures.
2. Start an Emergency Fund
Building an emergency fund is another vital financial step. This is your stash of cash to dip into if there are unexpected expenses, so that you don't have to resort to borrowing money when unexpected financial challenges arise.
3. Use Credit Cards Responsibly
Using credit cards responsibly is essential. Limit the use of credit cards to planned and necessary expenses, and make it a habit to pay off your credit card balance in full each month to avoid high-interest charges.
4. Plan and Save for Big Purchases and Expenses
Planning for big expenses, such as vacations, home repairs, or a new car, is crucial. Instead of relying on credit, it's wise to plan for and save for these expenses in advance. Plus, the planning and saving makes it so much more satisfying when you can finally afford it!
5. Live Within Your Means
Living within your means is a fundamental financial rule. Don't give in to the pressure of keeping up with extravagant lifestyles. Make financial decisions that match your income and long-term financial goals.
In his blog post on Good Debt and Bad Debt, investment specialist Nicolas Oldert reminds us: “You wouldn't be considering the card if you had enough cash on hand to buy what you wanted. Think about it – if you have the cash you don't need the card. So as soon as you're tempted to get a store card, remind yourself that you're spending money you don't have. That's not a good idea.”
6. Prioritise Your Financial Literacy
Prioritising financial literacy is a very important step on your financial journey. Educate yourself on basic financial concepts. If you are not sure where to start, check out the Franc Academy, a free financial literacy tool to help you improve your financial knowledge and help you manage your money better.
In his blog post about debt traps, our CEO Thomas Brennan shares: “When I got stuck in a debt trap, what hurt the most is that I didn't know how much I owed and to whom. Knowledge is power.”
Avoiding bad debt is a vital step in achieving financial freedom and security. By understanding the difference between good and bad debt and following these practical tips, you can safeguard your financial future. Financial literacy plays a significant role in making informed decisions about your money, so invest in your financial education to steer clear of the debt trap. Remember, with the right knowledge and discipline, you can enjoy a life free from the burdens of excessive debt.