What is Good Debt? (Good Debt vs. Bad Debt)

Despite attempts from banks, financial companies, and many charities, the conversation around debt is still very much muted, shirked, and clouded by negative connotations and anxieties. While it’s true that some debt is avoidable and should be avoided, some types of debt can actually be beneficial in our lives and should be treated as such. Read on to discover when and when not debt can be good, what “good debt” looks like, and what the differences between good debt and bad debt are.

What is debt?

Debt is defined as being any sum of money owed from one party to another. It can be small or large, depending on how much is borrowed and varies in type from a small short term loan, to a mortgage, to potentially millions of pounds in business loans. It’s important to remember that most debts will have interest fees that, if unpaid, will accumulate and thus increase the amount of debt owed. The vast majority of debts are taken on in order to finance or fund something that the debtor wouldn’t be able to afford otherwise, such as a university degree or business venture, but they can often be taken out to fund day to day living in difficult times.

Under what circumstances is debt good?

Debt is considered good in any circumstances where it might improve your net worth over a long period of time. These debts allow you to build up your credit score to engage in more expensive purchases in the long run, and when paid off the debtor finds themselves more well off than they were at first. Although these debts might be high value, “good debt” often doesn’t cost the debtor much more than the value of the initial loan, in part thanks to their lower interest rates.

What does “good debt” look like?

“Good debt” often comes in the form of low interest, relatively high-value loans. The value of these loans will dictate roughly how much better off they leave the debtor, so one which leaves the debtor with the foundations of a new business, for example, can be considered a “good debt”. The loan would need to have a low interest rate, as a high-interest loan can leave the debtor in a situation where they can’t afford to pay off their debts. These “good debts” include examples such as student loans, which are managed by the government at a low-interest rate where you may not even need to pay the full sum, and mortgages, which provide a highly valuable tangible asset to the debtor once the debt is paid off. In the case of all “good debts”, once repaid the debtor will find themselves better off than if they had never taken on the debt in the first place.

What does “bad debt” look like?

These debts are often at an incredibly high-interest rate, for smaller sums of money. In these cases, paying back the debt becomes incredibly difficult, as the debtor was struggling with money in the first place and the high-interest rates would just cause the cost of the loan to spiral out of control faster. These loans ultimately damage the credit scores of debtors and just lead to lenders making money, rather than the debtor having an opportunity to increase their net worth through loans. Examples of bad debt include credit card debt that is paid off in a series of very small installments, keeping you “in the red”, and payday loans or overdraft fees, all of these are debts that you may be stuck with for a long period of time as you struggle to pay off any interest or fees.

What are the differences between good debt and bad debt?

“Good debt” is often held through reputable institutions such as big banks or long-standing lenders, through an agreement that secures the rights of the debtor and keeps the costs through interest reasonable and low. This allows good debt to be manageable and ultimately mutually beneficial for everyone involved. On the other hand, “bad debt” often features significant interest rates and long-run costs for the debtor, meaning that they often take a much longer time to pay off and impact the credit score of the debtor in a way that can take years to fix. This means that in the long-term, taking out “bad debt” can force your mortgage to have higher interest rates, and even mean you get denied for certain loans. Whenever you need a loan – be it an emergency short-term loan, or a longer term car loan – make sure that the debt will be beneficial for you in the future, or you could be dealing with the consequences for years to come. Remember – if you are having any issues with debt, speak to one of the UK debt charities listed here.

The absolute beginner’s guide to APR

Navigating the world of UK consumer finance can sometimes feel like a bit of a minefield. With so many acronyms and financial jargon to sift through, it’s no wonder people can feel overwhelmed when looking at loans, credit cards, or mortgages. One of the most misunderstood financial concepts out there today is APR, or Annual Percentage Rate.

If APR is a bit of a mystery to you, don’t worry. In this guide, we’ll explain exactly what APR is and give you all the info you need about how it applies to your finances. Let’s get started.

The basics: what exactly is APR?

In a nutshell, APR — Annual Percentage Rate — is the measurement by which consumers can judge exactly how much financial products will cost them in the long term. These products could be credit cards, mortgages, loans, and other forms of lending.

Though APR is easily confused with an interest rate, the two are different, because APR is the total cost of the borrowing, including not just the interest rate, but also any admin fees charged by the lender. APR is a quick way for a potential borrower to understand exactly how much the borrowing would cost in total over a single year. For example, if you were to borrow £1000 with 6% APR, you would pay back a total of £1060.

The two flavours of APR: fixed vs. variable

When you’re making lending decisions, you’ll often see two different options when it comes to APR: fixed and variable. Simply put, a fixed APR means that the rate will not change from year-to-year over the duration of the lending period.

Conversely, a variable APR means that the rate you pay on the borrowing could potentially change as new years roll around. While this may sound concerning, it’s important to note that most lenders use a fixed APR, and those that don’t are required to provide notice in writing to borrowers.

There are also regulations governing how much a variable APR can change during the lending term, so you don’t need to worry about a jump from 6% to 60%, for example. If you have questions, be sure to raise them with the lender before committing to borrow.

What does “representative” APR mean?

Because everyone who applies for a credit-based product has a different credit history, each will be offered a slightly different rate for the borrowing.

For this reason, it’s very difficult to give a single APR figure which applies to everyone. To solve this, lenders use representative APR, which is simply the rate which they provide to 51% of their customers. This calculation is set out specifically by law so that consumers can make an informed decision.

By way of example, imagine that you’re applying for a credit card that offers a representative APR of 17.9%. This simply means that 51% of people were offered this rate – but the remaining 49% were offered a different rate (usually a higher one). To make your borrowing decision easier, most lenders are required to provide an example of the cost for the representative rate.

What factors affect the calculation of APR?

As explained above, the Annual Percentage Rate is not just the interest rate for the borrowing – it includes other costs too. Most commonly, these costs are things like the annual fee for a certain account or credit card. In such cases, you’ll see a much higher rate because the fee will be included in the calculation along with the interest rate.

The other factor which plays a major role in the APR you’ll be offered is your credit rating and credit history. Lenders need to manage risk, and they do this by considering affordability and setting rates accordingly.

As mentioned, representative APR is the rate given to 51% of successful applicants, but it’s possible that you will be given a higher rate, too. All lenders will refer to your credit history to make a decision about a rate they feel is affordable and appropriate based on your credit score.

Another factor that is worth bearing in mind when thinking about APR is whether the lending is secured or unsecured (i.e. whether it’s been secured against an asset such as property). Lenders are far more likely to offer a low rate if they know that the lending is secured in this way. Of course, if you’re not comfortable with the APR you’re offered for a particular product, you’re free to refuse it before committing to the borrowing.

We hope this guide has given you the information you need to make a more informed decision about borrowing. APR can be something of a nebulous topic if you’re not sure what it represents, so having an understanding of the rate before you start applying for loans, credit cards, or mortgages will be a powerful tool in getting the best rate for you.