The difference between good debts and bad debts

No surprises earlier this week from the RBA, with the cash rate remaining unchanged. Whilst there was a small glimmer of hope that they might at least consider a rate cut, there was no hint of such a consideration in their narrative.

Australia’s four largest banks have now provided the following forecasts regarding the Reserve Bank of Australia’s (RBA) next cash rate cut:

CBA – Anticipates the first rate cut in February 2025.
Westpac – Expects the initial rate reduction in February 2025.
NAB – Predicts the first rate cut in February 2025.
ANZ– Foresees the commencement of rate cuts in February 2025.

In this week’s newsletter, we take a look at the difference between good debts and bad debts.

Good debt and bad debt are terms often used to differentiate between types of borrowing based on their potential to add or detract from a person’s financial health.

Good Debt

This type of debt is generally seen as an investment in your future, adding value to your financial life. Good debt typically finances assets or opportunities that increase in value over time or improve your earning potential. For example, taking out a mortgage to buy a home can be considered good debt, as property usually appreciates over time, building equity that can enhance your wealth. Similarly, student loans are often labeled as good debt because they enable you to acquire skills or a degree that can lead to better job opportunities and higher income.

Bad Debt

Bad debt, on the other hand, is borrowing for expenses that don’t contribute to financial growth or can quickly lose value. Credit card debt, especially for discretionary purchases like dining out, vacations, or electronics, is a common example of bad debt. With high-interest rates, this kind of debt can quickly spiral, making it difficult to pay off and harming your financial health without adding long-term value. Payday loans are another form of bad debt because of their high fees and short repayment terms, which can lead to a cycle of debt.

In essence, good debt typically finances opportunities that can lead to greater wealth, while bad debt often involves high costs for items that don’t hold or gain value. Understanding this distinction can help individuals make smarter borrowing decisions, focusing on debts that offer long-term financial benefits over those that could lead to financial strain.

How Do Lenders View Bad Debt?

When assessing a home loan application, banks generally view good debt more favourably than bad debt. Good debt, such as a student loan or mortgage, is considered an investment in one’s earning potential or assets. In contrast, bad debt, like high-interest credit card balances, indicates financial strain or poor spending habits. Banks see applicants with manageable, “good” debt as lower risk, while excessive bad debt can reduce approval chances or lead to higher interest rates.

Variable

The rates below are based on a $500,000 loan, with the borrower making principle and interest payments with a loan term of 30 years. The rates quoted may vary depending on the borrowers LVR.

1 Year Fixed

The rates below are based on a $500,000 loan, with the borrower making principle and interest payments with a loan term of 30 years. The rates quoted may vary depending on the borrowers LVR. At the end of the three year fixed period, the borrowers interest rate will revert to a standard variable rate for the life of the loan.