Many people think all debt is bad debt, but there are times when debt can be helpful. It may not always be easy to distinguish between good debt and bad debt. However, learning the differences can make it easier to determine whether your money’s going where it should or not.
If you’ve ever wondered about the difference between good debt and bad debt, here’s everything you need to know about both types of debt and their impact on your life.
What’s the difference between good debt and bad debt?
This debt includes the following:
- Mortgage balances
- Auto loans
- Credit card debt
- Other loans (ex. student and personal loans)
While these may seem like high numbers, it’s important to remember that not all debt is necessarily bad. In some cases, such as with a mortgage or student loans, the debt may be good.
The difference between good debt and bad debt is based on a few factors, including the purpose of the debt and the individual’s ability to manage it.
What is good debt?
Good debt can be any of the following things.
- Anything that is considered an investment. This could include debt related to property ownership, education, investing in a startup, or establishing your own business.
- Anything that specifically helps establish wealth and increase overall net worth. Again, this could include business ownership, business-related expenses, property ownership, and real estate.
- Financing for something that increases in value. If the value of the thing increases, it could be good debt. For example, real estate may be good debt if the market is favorable and the interest rates are fair. That said, if the investment or business venture fails, it could become bad debt.
- Loans with low interest rates and high value. In general, good debt has an interest rate below 6% and has the potential for growth or an increased value.
- Ability to get a tax break. Good debt is also debt you can write off on your yearly taxes for a tax break. This includes things like real estate and business ownership.
Examples of good debt
Although people’s interpretation of good debt vs. bad debt varies based on individual perspective and financial circumstances, here are some of the most common examples of good debt.
Mortgage. A mortgage is a loan for purchasing or, in some cases, refinancing a home. Most mortgages come at a much lower interest rate than other types of loans and credit cards. Mortgages are also tax-deductible, meaning they can help lower your yearly taxes.
Unlike renting a home, buying a home and making your loan payments on time allows you to build equity. Equity is the difference between what you owe and what the home is worth. Over time, and with favorable market conditions, the financed home could very well appreciate (increase) in value, thus becoming a major financial asset.
Plus, everyone needs somewhere to live – investing in homeownership could be beneficial in the long-term for you and your descendants.
Real estate loans. Just like with a mortgage, the purpose of a real estate loan is also to finance a property. However, there are a few other types of real estate loans, including residential, commercial, and real estate investment loans. Each loan has its own purpose.
For example, the purpose of a residential loan is to finance real estate on an individual level. On the other hand, larger businesses or real estate developers may need a commercial loan to finance real estate. Residential loans usually have lower maximums and interest rates than commercial loans. As for a real estate investment loan, this is essentially a loan that allows the borrower to finance an investment property instead of a primary residence.
Regardless of type, a real estate loan is good debt when the financed property appreciates, comes with manageable payments and low interest rates, and is tax-deductible.
Home equity loan. With a home equity loan, the homeowner borrows against the value of their home (the equity). Common reasons for taking out a home equity loan include debt consolidation and paying for expensive home repairs. Since home equity loans have an average interest rate between 3% and 12%, they’re a better type of debt than most other loans.
Home equity line of credit (HELOC). Similar to a home equity loan, a HELOC allows the borrower to use the equity on their home to get a loan. However, a HELOC works more like a credit card with a variable interest rate and a predetermined borrowing limit. A HELOC can be good debt when it’s used for things like home renovations or repairs, debt consolidation, or financing other expenses at a lower rate.
Student loan debt. Contrary to popular belief, student loans can be good debt because they help break the barrier to higher education for those in low-income households. Since more education often means a higher earning potential, student loans are often a good investment for those who need them.
However, student loans can easily become bad debt. This is often the case with those who end up owing tens or hundreds of thousands of dollars in student loans for a degree that isn’t highly valued in the workplace. Student loans are also bad debt when the borrower doesn’t have a clear plan or career trajectory after graduation.
Small business loans. At an average interest rate of 3% to 7%, a small business loan is a good form of debt if you have a solid business plan and are prepared for business ownership. However, owning a business comes with its share of risks, so it is possible to lose out on the investment and turn good debt into bad debt.
What is bad debt
Bad debt is debt that does not allow you to invest, build wealth, or increase your net worth. It is usually used to finance consumable items, or items that depreciate (lose) in value over time. It also often comes with higher interest rates.
Examples of bad debt
Bad debt comes in many forms, but these are some of the most common types.
Payday loans and other short-term loans: Payday loans have high interest rates and other fees that make them incredibly risky and difficult to repay. In fact, the average interest rate on a payday loan is around 391%, though it can go higher depending on the lender. These and other high-interest debt can often trap borrowers in a vicious cycle of debt that can last for years.
While some lenders offer short-term loans at a more reasonable rate, they still come with other fees and penalties. Plus, most people take out short-term loans to pay for consumables or temporary things like vehicle repairs or medical bills.
Credit card debt: One of the most common forms of bad debt is credit cards. Credit cards have an average annual percentage rate (APR) of 15.91% and are typically used to fund consumables. The average American consumer has a credit card balance between $3,177 and $7,155, depending on their age.
Auto loans, car loans, title loans: These types of loans use a vehicle as collateral, meaning if the individual fails to pay back what they owe, the lender can seize the vehicle instead. Auto loans are a form of bad debt because vehicles start to depreciate nearly immediately after purchase. Title loans are also bad debt because they’re risky and, in many cases, have APR that rivals short-term or payday loans.
In certain cases, such as when a vehicle is essential to helping you keep your job or increase your income, an auto loan could be considered good debt. If the vehicle itself increases in value, which does happen rarely, it could also be good debt.
Personal loans: Personal loans are a tricky one because things like interest rate, loan terms, and even loan amounts vary based on the lender and the individual’s qualifications. If you’re using a personal loan to pay for something consumable though, then it’s probably bad debt. That said, a personal loan can also help you improve your credit score, which could allow for better financing options in the future.
Want to know more about good debt vs. bad debt? Rich Dad, Poor Dad author Robert Kiyosaki breaks it down in this video:
How to focus on good debt over bad debt
If you haven’t taken on any debt yet, or if you’re weighing your options, ask yourself the following questions:
- In five years, will I have something to show for this debt?
- Do I absolutely need this thing – car repairs, medical bill, money for vacation – right now? Is it possible to save up for it instead?
- Are there any other ways to pay for this?
- Can I get a better interest rate on a loan?
If you’re trying to avoid bad debt, try to wait until you have the funds to pay for whatever it is you need. When that simply isn’t possible, look for a lender that offers the best interest rates and terms.
Along with this, try to avoid using high-interest credit cards for daily expenses or smaller purchases unless you can pay the balance off in full each month. Interest rates add up faster than you might realize. If possible, only keep one or two credit cards, ideally those with the best rates, for emergencies.
If you already have bad debt, there are some ways to make it more manageable. Start by creating a budget to figure out your current expenses in relation to your total income. Once the budget is in place, you’ll be able to start paying down the debt little by little. If you’re having a hard time paying more than the minimums, consider taking on a side gig or picking up some extra hours at your job to increase your monthly earnings.
One method you could try if you have various forms of debt – good and bad – is to focus on paying off the smallest amount first, regardless of interest rates. This is the snowball method and it’s a great way to help you stay motivated and make progress.
Another option is to use the “debt avalanche” repayment method. With this method, focus on the debt with the highest interest rate first and make minimum payments on any other debt. Once that’s gone, start paying down the debt with the next highest interest rate and so on.
Good or bad, pay off all debt as quickly as possible
Whether you have good debt or bad debt, or even if you’re not sure how to categorize each type of debt, the best thing you can do for yourself is to start paying down that debt as soon as possible.
In brief, do the following:
- Assess your financial situation to see where you’re currently at and where you want to be. Consult a financial advisor or nonprofit credit counseling service if you aren’t sure where to start.
- Next, break down your monthly income to determine how much you can afford to pay every month.
- Cut back on unnecessary expenses like monthly subscriptions or dining out to help increase how much you can put towards things like credit cards and loans.
- Try to pay more than the monthly minimum on any existing debt (unless you’re following the snowball or debt avalanche method).
- Focus on paying off one debt at a time. That way, you won’t get overwhelmed by it.
By getting rid of your debt a little at a time, the rest of your finances will start to improve and other debts will become easier to manage.
Having a good mix of credit, or different types of credit accounts, has an impact on your credit score. Different types of good debt, like a mortgage or student loans, show up in their own sections on a credit report and count towards the overall mix of credit. As long as you make on-time payments every month, good debt (and some bad debt) can help increase your credit score.
Bad debt also counts towards having a mix of credit. The difference is that bad debt also tends to accrue more interest. This often leads to having a higher credit utilization and a lower debt-to-income ratio, which could negatively impact your credit score. Additionally, if you open several accounts at once, whether they’re considered good or bad debt, this could also cause your credit score to drop a few points. This drop is usually temporary and your credit score should recover within six months to a year.
This depends on several factors, such as personal circumstances, the ability to make on-time payments, and interest rates. In general, you should try to keep your debt to no more than 36% of your gross income. This includes everything from housing expenses to auto loans and credit cards. Try to avoid taking on debt you aren’t completely sure you can safely handle.
Interest rates play a major role in personal finance. The higher the interest rate, the more you’ll need to put towards the monthly balance of whatever debt you owe. Higher interest rates also mean paying more for whatever it is you’re purchasing or financing in the first place. Lower interest rates mean paying less on the loan.
With higher interest rates, it may be difficult to manage your money each month. You may end up missing payments, which could affect your credit score or lead to high late payment fees. Even if you don’t miss payments, high interest rates combined with debt can make it harder to save or invest money since you have less disposable income each month.