Debt can have a positive or negative impact on your business. That is why there is bad debt and good debt. For many people, debt has a negative connotation. However, debt can lead to the growth of your small business like expansion and in this case, that would be a good debt.
In this article, we are going to focus on good debt vs bad debt for small businesses and their differences.
What is a Good Debt for Small Businesses?
Good debt is money borrowed to pay for assets that will contribute to the growth and development of your business. Good debt should have low interest, have favorable payment terms and your business should be in a position to repay it.
What is a Bad Debt for Small Businesses?
Bad debt is money borrowed to buy items that depreciate or items that do not lead to your business growth. Bad debt normally leads to a reduction of your business's future value. Some of the ways to take note of bad debt is that it usually has high-interest rates and unfavorable payment terms. Examples of bad debts are payday loans and credit card debts. These loans usually attract very high-interest rates.
Good Debt vs Bad Debt
Good debt is a debt that adds money to your business while bad debt is a debt that takes money from your business. For instance, if you have a debt and use it to purchase equipment that will increase your business production, that is good debt. However, if you have a debt that does not lead to growth in your business, that’s bad debt.
Differences Between Bad Debts and Good Debts
|Increases your business net worth
|Decreases your business net worth
|Attracts low interest rates
|Attracts high interest rates
|Has favorable repayment terms
|Has unfavorable payment terms
|Items bought often appreciate
|Items bought often depreciate
Good Debt vs Bad Debt Examples in Business
The following are examples of good debt and bad debt in your business.
1. Good Debt
Mortgage debt: You can get a mortgage today and use it to buy land and build premises for your business. In the next 20 years, after you have repaid your loan, the value of the land and building could be three or four times the mortgage value. That's a good debt.
Small business loan: You can go to a bank or a credit union and borrow money to buy equipment for your business. The equipment leads to higher production in your business. Consequently, your business revenues increase and you can repay the loan and interest.
2. Bad Debt
Payday loan: You can get a payday loan to cater for quick cash needs for your business like payment of business utilities such as electricity. Payday loans attract very high-interest rates and can make your business slide into a debt trap. This is bad debt.
Credit card loan: You can borrow a credit card loan to make small purchases for your business. These purchases may not be directly related to production in your business. Besides, credit card debt attracts high-interest rates. As a result, interest payable can accumulate very fast. This is bad debt.
Considerations When Taking on Debt for a Small Business
Before borrowing, there are a few factors you need to consider:
- Interest rates. Ensure that the loan has reasonable interest rate and other fees like origination fees.
- Rate of return on investment. Ask yourself if when you invest in the loan, will the returns be higher than the interest. If it is not the case, drop the loan.
- Purpose of the loan. If you are borrowing to buy an asset that will depreciate in value, this is bad debt and does not lead to an increase in the net worth of your business in the future.
Summary of Good Debt vs Bad Debt for Small Businesses
Good debt is a debt that leads to an increase in your business net worth in the future. In short, it is a debt that increases money in your business. On the other hand, bad debt is a debt that takes money out of your business. If you borrow money to buy an asset whose value depreciates, that’s bad debt. As such, strive hard to take on good debts that can lead to growth in your business.