Not all debt is equal: How to tell the difference between good and bad credit

Jeanette Makings
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Rising personal debt is clearly a worry at the forefront of the Bank of England’s collective mind. The figure of the nation's debt currently stands at about £1.5 trillion, an average of £28,000 for everyone aged over 16 in the UK.

Such an eye-watering figure has naturally triggered a flurry of warnings from the Bank, and may even trigger prudential action.

But not all personal debt should be viewed in the same light. For example, some debt is affordable and makes up part of an overall financial plan that allows individuals or companies to invest in their futures.

Read more: Subprime car loans could be fuelling the next financial crash

The bigger picture

Most people incur debt at some stage in their life, and much of it is good debt. Whether taking out a loan to pay for further education, borrowing money to invest in a business, or taking out a mortgage to pay for a house, this type of debt is far from uncommon.

What makes the debt good is that it is planned, it has been researched and the best fit has been found. The debt must be affordable and have a clear investment in your future and one which, in theory, should mean you are better off in the long run.

This might be because of your ability to apply for higher paying jobs after gaining a university degree, owning a property rather than renting, or making returns from the investment in your business. This could also involve consolidating existing debts into a cheaper loan, or remortgaging, for instance.

Providing there is a clear plan to pay back the debt and the terms are realistic and affordable (even when interest rates change), taking out a loan is not a bad financial decision.

Don’t be hasty

However, loans which are taken out without any prospect of making you better off financially in the longer run, are a different proposition altogether. These tend to be linked to shorter term buys such as holidays, cars, clothes or other products. Or a loan could be taken out to meet unexpected financial shocks such as a car break down or a broken boiler.

Failing to shop around among providers, or picking the wrong financial product, can easily mean a debt that starts out as good ends up being bad. It can also make the impact of bad debt more significant by adding unnecessary cost.

Credit cards, for example, are not a recommended source of finance if the debt won’t be repaid within the same month or within the zero percentage charge period.

Borrowing more than you can afford to pay back across multiple debts can leave many people in precarious situations, so even with good debt, you should consider how you’ll meet repayments if interest rates rise or you have an unexpected drop in income.

For the consumer, it’s crucial that they understand the terms and conditions attached to repayments, as well as having a Plan B should any of these unexpected circumstances arise.

Costly concerns

Debt can prove to be more than a financial burden. Having unpaid debt often causes anxiety and stress which, for example, can affect performance at work, as well as quality of life.

Research we conducted with the Chartered Institute of Personnel and Development (CIPD) found that a quarter of people in the UK are suffering with money problems so substantial that it affects their ability to do their job.

The number reporting problems rises to a nearly a third among 18 to 24 year olds, and for those people living in London.

The problem is not limited to low earners either, with one in five employees earning £45,000 to £59,999 saying that financial anxiety has affected their ability to do their job.

Alleviate the debt addiction

Part of tackling this problem is for employers to help employees understand the difference between good and bad debt, and to provide support to help people manage bad debt and reduce their financial worry.

Not only will this help those anxious about affordable debts that may be perfectly normal part of financial planning, it will improve financial decision-making.

In doing so, this will support morale and productivity. For those unable to manage repayments, then debt counselling or using a company’s Employee Assistance Plan can help.

Most of these plans will have a debt counselling facility and they will be able to help quickly and confidentially. Increasing awareness of these services, and removing the stigma around using them, will be vital.

Know when credit is necessary

As the Bank of England frets about the growing mountain of personal debt which UK citizens possess, it’s clear that education is vital.

Debt is frequently necessary, often helpful in financial planning, and not all debt should be seen as negative.

However, helping employees identify what constitutes good and bad debt, and understanding how good debt can become bad is a vital place to start when trying to tackle an over-reliance on borrowing.

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