Go back a couple of generations and you'll find people like our grandparents thought that all debt was bad debt. Their rule was don't buy what you can't afford. If you wanted something, you saved for it first.

Times have changed. Our mantra is buy now, pay later. Today we put what we want on our credit and store cards to fret over another time. The card companies and our retailers thank us for it.

Perhaps that's too harsh. Credit and store cards do offer convenience. They're much easier (and safer) than carrying wads of cash in our pockets and they work well for shopping online.

But with the typical Australian credit card now laden with over $3000 of debt (at rates of 15 to 20 per cent or more), it's time we thought hard about being smarter with our finances.

Let's consider the difference between good debt and bad debt.

Good debt

A debt is good if it produces wealth or some form of income. A mortgage, for example, can be a good debt because the value of a house is likely to improve over time, creating a capital gain.

Good debts occur when you borrow to invest in something that will generate wealth and positive cash flows, such as property and shares which are likely to generate capital gains or an income stream through rent or dividends.

Consolidating debt can likewise be good. Transferring high-interest debts (such as credit and store cards) under the umbrella of a low-interest debt, such as a mortgage, results in lower interest payments which in turn saves you money. (But remember, you need to change your spending patterns and stop borrowing after consolidating loans to prevent your financial position from getting worse).

Bad debt

Bad debts are those you enter into to buy things that are going to decrease in value. This might include electronics, furniture or shoes which will all drop in value as soon as you walk out the door.

It also includes borrowing to pay for your lifestyle for things like clothes, entertainment and expensive holidays. Of course there's nothing wrong with splurging out once in a while, but when it's done regularly using credit - and when the debt isn't paid off fast - financial problems can start to take hold.

Bad debt can linger, even when it's paid off

Relying on credit and losing track of your purchases is the quickest way to overextend your finances.

When people get into trouble, it's often bad debt that's at fault. Be aware that if you default on your credit or store card, utilities or telephone bill the event is recorded by agencies such as Dun and Bradstreet and Veda Advantage.

If this happens, your credit rating will suffer. This can considerably harm your chances of qualifying not only for good debt (such as a home loan) but for any kind of loan at all. (See our article What happens when you have a bad credit history?)

Get rid of bad debt

To know whether a debt is good or bad, ask whether what you're buying will go up in value or deliver you some kind of income. If it won't, think twice about using credit to buy it.

If you do buy on credit, pay the debt off as soon as you can to limit the interest you'll pay. Try to clear all your bad debt as quickly as you can.

Lastly, remember that even though ‘saving before buying' has gone out of fashion, our grandparents' generation knew how to dodge bad debt. A good debt will improve your financial situation. The only good way to skirt bad debt is by living within your means.

Thinking about a mortgage? See the range of home loans offered by our lending partners or speak to a broker about a mortgage today.