I started putting this as part of another topic and decided it needs more consideration. It was going to be part of a topic on Investments and whilst it still is, I think it better to take a look at Debt on its own before exploring other areas.

What is Debt?

Stop and think about this question before answering it. What does Debt mean to you? Perhaps it is worth stopping here and writing your answer down, make a comparison to what I am suggesting. I have spoken with many people and there appear to be many differing views on what Debt really is. I’ll save my answer for later!

Not all Debt is a bad thing. We go into Debt to buy a house to live in. Some people also use it to buy a car. These debts are not all that bad really when you look at it. Who can afford to buy these things outright in the first place? Surely it is better to have a house you are buying than paying off someone else’s loan as you rent? Almost always the answer is yes, this is a good idea. For many people these things are not being in Debt, they are part of our daily lives, an expectation.

I have a son who has just bought into his first home at the age of 24, he bought in with a friend. Between them the maximum they could afford to borrow was $500,000. How much did they borrow? Yes, $500,000. Both have reasonable jobs and a good income. With the first home buyers they have been able to buy a few things they need to make the place comfortable, you know, the flat screen plasma, new leather lounge and bedroom suite, all new and the better quality!  To me, this is a bad debt because they have left themselves with no reserves.

When investigating the possible loans online, all the loan calculators give you a figure of what the maximum is you can afford to borrow, therefore what you can manage to repay. How many people look at the figure and then look for something less than the amount you can borrow? Check with your friends on what they did? What did you do? Did you look for something cheaper, in an area that you perhaps didn’t want to live in or something run down, or did you borrow the maximum and then struggle with the Debt.

Our venture into the housing market came at a time when prices were going up very rapidly, if we didn’t get into the market soon, it might have been impossible, or at the very least, difficult. So we organised our finances and started to research what was available. We looked in a number of areas and locations, finally making the decision to buy something on a fairly major road. The prices of other houses in the same area but not on such a busy street were considerably more. It got us into the market and we have kept pace with houses in the area, something we couldn’t have done by simply saving. It is by no means the perfect house but we have developed some attachments to the place. We have been able to pay it off quickly because it was well within our affordable range. We now have considerable equity in the house, and could sell and upgrade any time we want to.

I spoke with a young chap about his plans for the future, he wants a house, was paying off the car, planning his wedding etc. His plan was to move into a suburb that was going to stretch his finances. We spoke about what other options he could possibly look at, perhaps a smaller house or another suburb that was more affordable. All good options, yet he stuck with his plan and is probably going to struggle for many years. This isn’t just a financial burden but can also put stress on a young family and limit other options. Why not get into the market with something more affordable and pay a larger amount off, or as much as you can afford, then use it as a stepping stone for the place you really want to be in. Instead he’s struggling, so this is definitely what I would call a bad debt!

The other bad debt is the one to purchase all those things you really can live without but must have anyway. The personal loan or credit card, things you want to have in the house, or items that you should really look at saving up for rather than buying right now. These are ‘wants’ rather than needs. The thing here is to look at what the debt is going to do to you, both short term and long term.

In a previous Monday Money I wrote about Credit Cards, and the money being borrowed. All debt is borrowed money and has to be repaid at some stage. We need to look at ways of changing our purchasing power so we use what is already ours, rather than getting a loan from someone else. The borrowed money needs to be considered as living beyond our means in the first place. Surely if we can afford the item then we can pay cash for it or save the money to buy it.

So what is my definition of Debt? I would like to suggest the term covers any ‘money you have borrowed’ for the purpose of purchasing something you want or need. It is money that you have not yet earned, so belongs to someone else and therefore has conditions attached for its use. These conditions include things like having to repay the money along with interest, fees and charges. In other words it is going to be more to repay than you originally borrowed.

Therefore I would suggest that there are 2 types of Debt. I place these into 2 categories, the good and the bad. The good debt covers the things like a house to live in, something that you can afford to pay off in less than the term of the loan. I would also include a second hand car, something cheap, reliable and affordable, again paid off inside the life of the loan. This should be done without having to stretch the budget, perhaps using the repayment amount for the maximum you could have borrowed, but actually borrowing less to pay it off sooner. Bad debt is any loan, including credit cards, for the items that with disciplined saving you could afford to pay cash for and avoid fees and interest. Or any loan for something you didn’t really need!

I’ll leave you with a question this week. According to my 2 types of debt, which have you got?

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