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The Lendified Blog

 

Good Debt vs. Bad Debt and Your Small Business – Understanding the Difference

You’ve landed here because like many, you want to understand the differences between good debt and bad debt, so you can manage your small business finances more optimally and strategically.

In many cases, the differences between good and bad debt are clear. For instance, Payday loans or cash advance loans are widely regarded as bad debt, and for obvious reasons. These loans are often referred to as “predatory” as they prey on individuals with bad credit or low income, who have few other options available to them – such lenders charge extortionate rates with inflexible terms that border on unethical.

Credit cards are also considered bad debt and are too often abused or misused by consumers and small business owners alike. Credit cards are convenient for day-to-day expenses and automatic payments, as long as a balance is not carried from month to month. Credit card rates are incredibly high compared to other forms of debt such as small business loans and emerging online lenders, like Lendified, and the payment terms are structured in such a way that the costs are higher and more profitable to financial institutions.

Essentially, any form of debt with high interest rates, high fees and inflexible repayment terms are considered bad debt. Also, borrowing funds to purchase anything that depreciates in value over time is considered a form of bad debt. Cars, clothes and furniture all fall under that category.

Fortunately responsible small business owners seeking fast access to capital to invest in growth have many other options.

So, that begs the question: Are there good forms of debt? Of course there’s such a thing as good debt! Smart, calculated, low risk investments at a low rate loan are good forms of debt that can be healthy for your small business. After all, it takes money to make money, right?

Good debt should be viewed as an investment in your business – expansion, growth, opportunity, promotion and professional development are all common examples. Education, for instance, is considered a form of good debt because education is a predictor of career success and lifetime income earnings. The key is, there needs to be a direct line between borrowing and earning. At the very least, you must be confident you can repay the loan and then some – meaning interest and fees must be taken into account as well.

As mentioned before, taking on good debt means borrowing to invest in things that don’t depreciate over time. So while utilizing a loan to expand your business may drive growth and expansion of your business, borrowing funds to decorate your business space according to the latest trends might mean taking on bad debt... if the look will go out of style before you even repay your loan!

Similarly, good debt can mean utilizing funds to mitigate a loss or crisis. For instance, in the event of a breakdown in equipment that is essential to your business, it makes sense to take out a low interest rate loan to repair or replace that equipment, as long as the losses mitigated are equal or greater to the all-in cost of borrowing (amount, fees, interest). Either way and whatever the purpose, good debt means that overall you and your business must be financially better off in the end.

Then we come to a bit of “grey area” as it pertains to debt. We see this in our professional lives as small business owners as well as in our personal lives.

Take the case of credit card rewards programs for example. Watching your points pile up can be a rush, and it’s easy to see the benefit in free flights, techie toys and extra cash. Just be sure that when you do the math, the benefits tally up to greater value than the interest spent! As mentioned above, credit cards are one of the worst forms of debt you can take on.

Investing is another hotly contested area when it comes to debt. It’s not unusual for investors to leverage their investments – borrow at a low rate for a high-return investment. But, of course, there is no such thing as a sure thing and there is enough risk here that it is not a form of “good debt” in the traditional sense.

Debt Consolidation loans are another area that invoke varying responses with respect to how “good” or “bad” this form of debt is from a financial wellness perspective.

In the case of responsible, sound business management, debt consolidation is a good debt management strategy to ensure you're paying the lowest rates and according to the most ideal or flexible terms possible. Where debt consolidation loans can be problematic is in the case of bad financial management, excessive borrowing and debt. Restructuring your debt into a consolidated loan for the purpose of accessing more cash flow to go deeper into debt is simply bad business. If utilized appropriately, a debt consolidation loan is a smart way to mange your small business debt.

The lesson here is that debt is not always bad and it is certainly nothing to fear or be ashamed of. When handled effectively and strategically, a good debt management strategy can be fundamental to your small business success.

About the Author: Michelle Pinchev