7 Good debt, bad debt?
The impression you might get from some sections of the media is that all debts are bad. Such views are simplistic. For most people borrowing money is the only way they can afford to buy property, cars and other expensive goods. Of course, some borrowing is ill-advised, but in most cases people are making sensible, and affordable, choices when they borrow money.
Activity _unit7.7.1 Activity 4 Case studies on debt
Here are four case studies of debt. Some are good debts (sensible borrowing) and some are bad debts (ill-considered borrowing). Work out which category each case study falls into, and why. As you’ll see, it’s not always straightforward.
Case study A
I've been saving up to get a mortgage, a place for me and my family to live. We've managed to get a big enough deposit, it's over 10%. We're looking for somewhere for the long term, not an investment. We're getting a fixed-rate mortgage for five years. It's affordable and is actually cheaper than our current rent. Good debt, bad debt?
Borrowing in these circumstances is a no-brainer. The funds would be used to buy a property and save money at the same time. So it’s a good debt.
Case study B
I've just seen a holiday to Jamaica. It costs £5000. I earn £19,000 a year, but the bank says they'll lend me the money. Good debt, bad debt?
Clearly this is a bad debt. Borrowing more than 25% of your annual income for a holiday looks reckless. The loan is likely still to be in the process of being repaid months, perhaps years, after the holiday is over. The loan repayments could well cause budgetary problems too for the borrower.
Case study C
I lost my job six months ago and it's been a real struggle to find a new one. This week, I've just been offered a new job. It's in the countryside. I'm going to have to move myself and my family, but we've found a house we can afford to live in. The problem is we always went by public transport in the past, and where we're going to be living now, my kids’ school is 7 miles in one direction and my work is 8 miles in the other direction. I need a car. But I've got a very bad credit score because I've been unemployed, so it's going to cost me 20% interest on the loan and the repayments over 5 years are going to put me at the brink of affordability. I can just do it, just manage it on a single income. But I've got a 3-month probation period on my job. If I don't get the car, I can't get the job. If I get the car and take the job but fail my 3-month probation I'm totally gone because there's no way I could afford to pay back the loan, and, frankly, it'll push me over the edge. I'd go bankrupt. Good debt, bad debt?
This is a more complex one. There is a risk in taking on the loan if the probation period is not completed successfully. In these circumstances the car could be sold to allow at least a large proportion of the loan to be repaid. The fact is, though, that most people do complete their probationary periods successfully and if this happens the borrower will be OK. I think that once the probationary period is completed and the job is confirmed the borrower should shop around for a replacement loan at a lower interest rate.
Case study D
I’m buying a house. It costs £250,000. I had £25,000 in savings for a deposit but the building society would only give me a mortgage of £200,000 over 25 years. To cover the difference I went online and borrowed the other £25,000 I needed through a 5-year bank loan. Good debt, bad debt?
This is a bad debt since it is unlikely the ploy will work. The mortgage lender will want to know how the £50,000 difference between the mortgage and the cost of the property is going to be bridged. When the £25,000 loan is disclosed the lender will, almost certainly, revise their mortgage offer downwards on the basis that with a bank loan to repay the borrower will have less money left to cover mortgage repayments. The borrower would then be back to square one with a new shortfall between the cost of the property and the money they’ve collected to pay for it.
So whether a debt is good or bad depends on the circumstances. Certainly debt is not always a ‘bad thing’. In most cases it provides the means to buy key assets like property and cars. And in most cases borrowers are able to repay their debts without financial stress to themselves or their families.