Good Debt vs. Bad Debt: How They Differ

“Although many see debt as a bad thing, it’s not always that straightforward. When you handle debt responsibly, it can actually be beneficial. Some types of debt can even help you build wealth. Knowing the difference between good and bad debt, and how to manage each, can make a big difference in your financial well-being.”

Key Points:

• Debt can be good or bad, depending on how it’s used.
• Good debt is typically used to build wealth or improve financial well-being.
• Bad debt is usually unaffordable or doesn’t offer long-term benefits.
• Even debt that’s initially considered good can become bad if not managed responsibly.

What is good debt?

Good debt helps you achieve financial goals, like buying a home or starting a business. It can also be good if it helps you build credit. Managing debt responsibly, such as making timely payments, is key to keeping it good. However, there are no guarantees, and debt you can’t repay on time can turn bad.

Examples of good debt

Here are a few types of debt that can be considered good debt under the right circumstances. Keep in mind, though, that any type of debt could potentially become bad debt in different circumstances—if you can’t repay it or it negatively affects your credit scores, for example.

1. Mortgages: Buying a home can be considered good debt because it typically appreciates in value over time, building equity.
2. Student Loans: Borrowing for education can be an investment in future earning potential, making it a potentially good debt.
3. Business Loans: Borrowing to start or expand a business can be considered good debt if it leads to increased income or profitability.
4. Real Estate Loans for Investment: Borrowing to purchase real estate for investment purposes can be good debt if the property generates rental income or appreciates in value.
5. Debt Consolidation Loans: Combining high-interest debts into a single, lower-interest loan can be a strategic move to pay off debt faster and save on interest, making it a form of good debt management.

What is bad debt?

Not all debts are equal. Some debts are considered bad because they’re hard to pay back or don’t give long-term benefits. These could be loans with high interest rates or tough repayment terms.

Before taking on debt, think about how it might affect your debt-to-income ratio. This ratio compares what you earn to what you owe. If the monthly payment for a debt is more than what you earn in a month, it might be tough to repay. This could be a sign that taking on that debt isn’t a good idea.

Here are a few types of debt that might be considered bad debt.

Debt You Can’t Afford: This is debt that you don’t have the financial means to repay comfortably. For example, if you take out a mortgage but your income isn’t enough to cover the monthly payments, it can lead to financial stress and potentially foreclosure, making it bad debt. It’s crucial to assess your ability to repay any debt before taking it on.

Credit Card Debt: Accumulating debt on credit cards, especially if you only make minimum payments or carry a balance, can lead to high-interest charges and long-term financial strain.

Auto Loans for Depreciating Assets: Taking out a loan for a car that quickly loses value can result in owing more than the car is worth, especially if the loan term is long and the interest rate is high

Personal Loans for Non-essential Items: Borrowing money for vacations, shopping sprees, or other non-essential expenses can lead to unnecessary debt, particularly if the interest rates are high.

Payday loans: Payday loans generally offer short-term, high-interest loans, often without requiring a credit check. These types of loans can have higher interest rates, and you usually have to pay them back by your next payday. Payday loans usually don’t get reported to any of the major credit bureaus. That means even if you do make on-time payments, your credit scores probably won’t reflect it.

How to avoid bad debt

Avoiding bad debt starts with understanding your financial limits and making informed decisions about borrowing. Here are some simple tips:

1. Check Your Budget: Before taking on new debt, ensure you can comfortably afford the monthly payments without stretching your budget too thin.
2. Consider Interest Rates: Compare interest rates on different loans. Lower rates mean less interest paid over time, saving you money.
3. Think Long-Term: Consider how the debt fits into your long-term financial goals. Will it help you achieve them, or could it hinder your progress?

By keeping these tips in mind, you can make smarter decisions about borrowing and avoid falling into bad debt.

Good debt vs. bad debt in a nutshell

Good debt helps you build wealth or improve your financial situation, like student loans or a mortgage. Bad debt doesn’t benefit you financially and can be hard to repay, like credit card debt for non-essentials.