All debt is not the same. Some types of debt, like having a mortgage, have a purpose, and can actually improve your credit score. The worst types of debt to have are those that make your situation worse, hurt your credit score, and keep you under financial stress.
Here’s a breakdown of the worst types of debt to have and how they hurt your future.
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1. Tax debt
No matter how much debt you have, owing money to the government is a major no-no. Not only will the government charge you interest, but they can also add penalties on top of the outstanding amount.
Another reason that tax debt is one of the worst types of debt to have is that HM Revenue and Customs (HMRC) can take enforcement action against you. While creditors can’t take your property if you have credit card or loan debt, HMRC can take money from your earnings or pension to satisfy a tax debt. They can also come to your home and take property so that they can sell it. They can even take you to court or take money directly from your bank account.
If you have tax debt, pick up the phone and contact HMRC to deal with it before tackling any other debt. If you’re struggling financially, HMRC might give you more time to pay or allow you to set up a payment plan.
2. Debt that you’ve defaulted on
Also at the top of the worst types of debt to have is any where you haven’t kept your payments up to date. When you default on a debt, it can end up with a debt collection agency, which means added fees and nonstop calls from collection agencies. Even worse, these debts end up hurting your credit score.
If you have this kind of debt and it hasn’t been sent to a collection agency yet, contact your creditor. You might be able to set up a payment plan to catch up. If the debt has already been passed to a collection agency, try to negotiate a settlement so you can pay it off and start rebuilding your credit.
3. Payday loan debt
High-cost short-term credit (HCSTC) loans such as payday loans sometimes have their place. If you are in desperate need of money but have poor credit, payday loans might be the only option available to you. The issue with these loans is that they only work if you can repay them on your next payday. Otherwise, their high interest rates and fees make them one of the worst types of debt to have.
According to the Financial Conduct Authority (FCA), 67% of the people using payday loans are over-indebted, meaning their credit and loan repayments are close to or more than their actual income. This is because the high-cost short-term payday loan cycle is very hard to break. With interest rates so high, most people continue to take one payday loan after another just to stay afloat.
You can use the StepChange calculator to see how much a payday loan will cost you. For example, if you borrow £500 and pay it back after 30 days, you’ll typically pay back around £620. However, if you’re late and pay it back after 60 days, the amount goes up to £758. After 90 days, that same payday loan will set you back £1000.
4. Car loan debt
Car loan debt is tricky to categorise. If you truly need a car and can’t afford to buy one in cash, a loan is your only option. On the other hand, a £15,000 loan for a brand-new car is rarely a good idea. This is mainly because cars depreciate quickly, so by the time you finish paying off the 60-month loan, your car will be worth 40%-50% less than when you drove it off the forecourt.
When in doubt, look at it this way: car debt is good when you can afford the payments and when having a car enables you to do something positive, like travelling to a better paying job. Car debt is bad debt when the car isn’t really necessary (you’re just upgrading to a more expensive car when your old one was perfectly drivable) and when you the payments are not affordable or seriously stretch your budget.
As a general rule, it makes more sense to buy a used car. If not in cash, you can always lease one that’s just a few years old. You will still have an almost-new vehicle at a much more reasonable price and a loan that you can pay back faster.