When you’re in over your head, all debt feels like its’s bad. However, there are some debts which are worse than others and debt is not necessarily a bad thing for your finances. When repaying any debt you have, it is important to pay off the ‘bad’ debt first and the good debt last to ensure that you save the most money possible.

Bad Debt
Bad debt is usually classified as anything which you struggle to pay the minimum amounts on each month and when you calculate the date when you will have finally paid off the debt, it will be way in the future.

High interest: Any time you take credit or a loan, interest will generally be applied. Rates vary hugely, and obviously the lower the rate you can get, the better. Anything with a rate of over 10% should be considered ‘bad’ because you will have to pay back substantially more than you borrowed in the first place.

Prepayment penalties: Any debt where you face a penalty charge if you want to pay it back early should be classed as a bad debt. Early payoffs save huge amounts of interest and you should be allowed to take advantage of this saving if you want to. If you are able to pay off a loan early and it has a prepayment penalty, it is worth checking whether or not it is more cost effective to pay the loan off early, or stick with the loan and not face the early repayment charge.

Depreciation: Anything which depreciates is bad debt. Cars, houses and clothes are good examples of bad debt. If possible, all of these should be bought outright if possible, and if not possible, with the largest amount of cash you have. If you take out loans to cover anything which depreciates in value, you will end up paying far more than the asset is worth in the long-run.

Good Debt
It depends on whether you believe that any debt is good. There are some debts which are ‘OK’ to have as they may have benefits associated with having them:

Low interest: It is always a good idea to pay off the higher interest loans first, even if the ‘lump sum’ associated with them is less. Take a look at our snowballing guide to see why it’s best to pay the higher APRs off first. Some credit and loans are at 0% for fixed periods. If you are smart, you can take the money away from the loan or credit, put it away in a high savings account for the duration of the 0% period and pay the entire loan back when the 0% period is up – it really is money for nothing, but only try this if you have a very tight rein on your finances!

Property: Mortgages can be seen as a good debt, particularly if the property is appreciating at a fast rate. It means that in the long run, although you are having to borrow money, you should end up with an asset which is worth far more than you paid for it.

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