Good Debt Vs Bad Debt: How to Tell the Difference

It can’t have been but a few weeks past that the entire country seemed charged with anti-debt sentiments. 

It all began with a particularly inspired graphic by Mutemi wa Kiama informing the ‘World at Large’ to withhold from any future debt arrangements with the President. 

What started off as little more than typical Kenyan humour soon grew into a sustained social media campaign against IMF lending. 

A widely circulated petition so far signed by over 234,000 Kenyans culminated in the IMF App on Google Play earning a 1-star rating thanks to outraged Kenyans.

There is a lot that can be (and has been said) about Kenya’s debt appetite. Certainly, more will be said as the year mightily drags itself along, but we will not be flogging that particular horse today (or any horses, any day really). 

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The topic for today is debt on a personal level and understanding what it means to us. Would it galvanise us to institute a petition against ourselves for our credit-taking practices? Impose a self-embargo of sorts against taking on any more debt? Most importantly, do we really understand the debts we take on and what they mean to us?

Talking Debt: The Good and the Bad

Debt, understood as money owed or due, has historically been divided into ‘good’ debt and ‘bad’ debt. The definitions for these being almost intuitive - good debt makes you money and bad debt costs you money. That’s it!

And with that the class would be dismissed and we could all go on our way having learnt all there was to be learnt about debt. It is deceptively, almost attractively simple and true enough. 

But, as with most things, there still remains a lot to be interrogated. Take this example for instance, education loans, would those fall under good debt or bad debt? 

The instinctive answer is that taking these loans can only count as good debt. However, a closer look at this may show us something more complicated.

Education Loans: Good or Bad Debt?

The Higher Education Loans Board (HELB) offered more than Ksh108B to over 927,610 students from when it was launched in July 1995 to September 2019.

Of that 2019 number,  229,631 had paid back their outstanding loans in full while 85,211 beneficiaries with Ksh10.6B obligation were in default. 

This led to a funding conundrum for the academic year 2019/2020 with HELB warning that unless this money was recovered, 113,953 students would not be awarded loans and would have to drop out of learning institutions. 

HELB, is undeniably, one of the reasons why access to university education has been within reach for many Kenyans. The question, however, remains, is it worth it? For student loans to qualify as good debt, a globally accepted rule of thumb is: don’t borrow in total more than you expect to earn in the first year in your chosen career field. 

Simply put,  if you plan to take out a HELB loan of Ksh 40,000 per year for 4 years, first figure out if your first year income will be more than Ksh160,000. At the bare minimum then each month you should be making about Ksh13,500. 

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This will account for the fact that HELB loans have a 4%  interest rate that comes into effect one year after one graduates from school. With these calculations in mind, you should have a good idea if the course you are studying will adequately cover your loan repayments while leaving you enough to live on. 

However, we have to acknowledge the other hidden factors: will you find a job within that time? How will industry rates have changed by then? Is the market looking for the skillset you are taking out this loan for? And most importantly, is there a pay-gap between those with degrees and those without?

Generally, student loans qualify as good debt simply because, on balance, across the globe the higher your level of education the more you can expect (and ask) to be paid. 

However as the informal sector grows and the gig-economy increases in size this general rule will find itself under stress and in need of re-evaluation.

The Short Answer

Good debt puts more money in your pocket than it takes out and bad debt does the opposite. It really is just a numbers game when it comes down to it. 

For instance, taking a personal car loan is generally bad debt for the simple reason that cars are depreciating assets.  

Once you take into account fueling, servicing, insurance premiums and the eventual re-sale value, a car is a liability that you should avoid buying on credit. 

Of course, these calculations change if you use it for business, say it’s a taxi or you use it to transport goods. At that point then the bottom-line changes and you may well find that despite depreciation, ultimately, it will have made you more money than it cost you.

Bad debt, on the other hand, is taking out money from your future self to give to your present self. 

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One common debt trap that sets this in motion is the phenomena of payday loans - borrowing money against your next salary. You could also call these short-term convenience loans. 

Owing to the interest payments that these carry, you’ll lose more money taking them than you will gain. Hence, these form a prime example of what counts as bad debt.

How to Decide

There are hardly any simple answers to borrowing money and certainly, if we had a choice, most of us would prefer to remain debt free. 

However, good debt exists in abundance and is sometimes one of the only ways to grow your business. You would be surprised (or not) to know that some of the richest people in the world have made their fortune from utilising credit. 

While we must exercise caution and temperance around debt, we should have a healthy enough relationship with credit to understand how we can use it to our benefit.

Even as we discuss bad debt, we must be alive to its nuances; borrowing money for rent, for food, for unforeseen medical expenses would generally fall under ‘bad debt’ as we are indeed taking money from our future selves to give to our present selves.

But then, such closed-off definitions fail to acknowledge that our future selves are very much dependent on the health and wellness of our present selves. 

As long as such borrowing is constrained to short-term situations and is not a symptom of living beyond your means then we should not cast stones based on the overly specific distinctions of the two.

Ultimately, taking on debt ought to be a well thought out and deeply researched endeavour, not to be done on a whim, and most importantly, to be approached with clear-sighted appreciation of the obligations such a decision gives rise to.