A few years back, Mr. X made the decision to open a café in his hometown. For this, he availed of a ₹10 lakh business loan with a 12% annual interest rate. Over two years, his café managed to garner enough loyal customers, his earnings comfortably covering his monthly loan instalments. That loan led to his entrepreneurial success.
That is in stark contrast to Mr. Y, who took a personal loan of ₹2 lakh at 18% interest to upgrade her car. A year later, the car’s value had depreciated by 30%, and she was struggling to keep up with the EMIs while also trying to save for her wedding.
Both borrowed money, but their experiences couldn’t be more different. Why? Because the business loan was “good debt,” while the personal loan turned into “bad debt.”
What is a Good Loan?
A good loan is like a seed you plant—it grows into something of value over time. It supports assets or opportunities that create income or increase in value. Smart education loans that lead to a better job, home loans for properties with an appreciating value, or business loans that get you started on a venture.
Let’s take an example: Someone takes an education loan to complete their MBA. They take ₹15 lakh loan at 9% p.a., but their salary doubles within a year of graduation. This isn’t just debt—it's an investment in the future.
Good loans have these traits:
- ✔️ Align with long-term goals.
- ✔️ Are affordable, with manageable interest rates and EMIs.
- ✔️ Offer a positive return, either through income generation or asset appreciation.
What is a Bad Loan?
Bad loans, on the other hand, are like eating junk food—they may satisfy an immediate craving but harm you in the long run. These loans are often used to pay for depreciating or discretionary assets, such as electronic devices, holidays or luxury items. Even worse, the high interest rates eat away at your finances over time.
Imagine a scenario where a person takes a loan of ₹1.5 lakh on a credit card to take a trip to Europe. Their debt compounds quickly if not paid within the due date, accruing at 36% to 42% per year. If they do not pay the interest for 2-3 years, then a few years later, they would be paying more in interest than they spent on the trip in the first place, forcing them to draw down their savings just to keep their heads above water.
Bad loans tend to have these traits:
- ❌ Fund non-essential purchases, commonly known as ‘wants.’
- ❌ Carry high-interest rates or hidden charges.
- ❌ Strain finances without offering lasting value.
Why Timing and Purpose Matter
Even the same loan can be good or bad depending on its purpose and timing. Let’s revisit the car loan example. If the ₹2 lakh had been used to buy a used car for a food delivery business, it might have been “good debt” because it would have generated income. Instead, the decision to splurge on a luxury model made it a financial burden.
Similarly, early financial discipline can transform the impact of loans. Someone who starts investing small amounts at 22 and uses a student credit card responsibly to build a credit score will likely secure a lower interest rate on a home loan at 30, saving lakhs over the loan tenure.
How Much Good Debt is ‘Good’?
It needs to be noted that while starting a food delivery business by loaning a car may sound fancy, a deep understanding of the business is also required to make returns on investment beyond EMI obligations.
Even a business loan, if taken without proper business understanding, can turn into a nightmare.
Due to various unforeseen circumstances, the value of an appreciating asset for which you could’ve taken a loan could also go down.
Say you went to the US and spent ₹1 crore on tuition fees for your bachelors but say, a recession breaks out there and you are unable to find a job there.
Say, for some reason, the national real estate market goes under stress and your house property (which you loaned) goes down in value.
Thus, it is very important that one doesn’t go overboard on availing good loans either.
While it is subjective, a healthy, good loan-linked EMI-to-income ratio should not exceed 10% to 20%.
How to Distinguish Between Good and Bad Loans
- Purpose: Does the loan fund an appreciating asset or a depreciating expense?
- Affordability: Are the EMIs within budget? A debt-to-income ratio of 30-40% is manageable.
- Impact on Future: Will the loan help grow financially or create stress?
- Alternatives: Could you save up instead of borrowing? If yes, it might not be worth the loan.
So One Should Never Take a Bad Loan?
You should never take a bad loan if you can’t afford it. What does that mean? It simply means that if you do not have the money to buy that depreciating asset (say, a car) or fund that trip now, you should never take a loan to afford it.
However, if you have the money and have stable cash flows coming from another source (say, fixed income products) that exceed the interest cost of the loan, you may consider and avail that loan. It is tough to find such arbitrage opportunities, though. A careful call may be taken by consulting a registered investment adviser.
A safe bad loan linked EMI-to-income ratio could be 3-5% of your income.
Final Thoughts
Debt is not good or bad—it is simply a matter of how it is used. It is always advisable to borrow with purpose and care so as to not go beyond what you can repay. Good debt is a step towards a better future, while bad debt is a step away from it. In cases where repayment becomes difficult, a loan settlement agency can assist in finding a solution. Ensure that you stay on the positive side and manage your debt wisely