Good Debt vs. Bad Debt: What’s the Difference?
- Good debt is debt taken on with a goal in mind. It likely offers low interest, manageable payments and the potential to improve your overall financial picture.
- Bad debt is debt taken on in a pinch — a consumer purchase or an emergency, for example. It may have high interest, put a strain on your budget and worsen your financial situation.
- Solutions to bad debt include consolidation, refinancing and other types of debt relief. A simple debt-repayment strategy, like the snowball or avalanche method, can also help you get out of bad debt.
Debt can be placed into two broad categories: good debt and bad debt. Good debt can help you get ahead financially when taken on wisely and managed well. Bad debt, on the other hand, can spiral out of control, harm your credit and tank your finances. Learning the difference between good and bad debt can help you avoid or get out of bad debt, take on new loans wisely and shore up your financial future.
Good debt vs. bad debt
Here’s an at-a-glance overview of what makes debt good or bad. There are various factors to consider, including the purpose of the loan, the impact it’ll have on your credit, any potential tax benefits and your ultimate financial or life goal.
| Good debt | Bad debt | |
|---|---|---|
| Examples | Mortgage, student loans, business loans, some auto loans | Credit card debt, payday loans, loans for second cars or boats, high-interest loans |
| Purpose | Grow an asset, improve future earnings prospects or make a necessary purchase | Fund a consumer purchase or experience, or handle an emergency |
| Credit impact | Can help you build good credit and improve your credit mix | Unfavorable terms (such as high interest rates and fees) could lead to making late payments, which damages your credit |
| Tax considerations | May offer tax benefits | Lacks tax benefits |
| End goal | Improve your overall financial picture by upping your earning power or building assets | Pay for a purchase or experience (such as a vacation or wedding) or handle a crisis |
What makes debt “good”
Good debt helps you improve your overall financial situation. This type of debt may offer low interest rates, manageable payments and tax benefits. Here are some examples of good debt, and why it’s considered good:
- Mortgage: A home generally appreciates in value over time, and can be one of your biggest assets. In fact, homeowners are, on average, 43 times richer than renters.
- Student loan: A student loan can fund an education that may boost your earning potential by a median of over $30,000 a year.
- Car loan: A car loan can be good debt if you need a car to get to work, choose a reliable vehicle and make sure your payment is no more than 10% of your household budget.
Keep in mind that good debt can turn bad if you don’t manage it correctly — so make sure the payments fit within your budget, and always pay on time.
What makes debt “bad”
Bad debt is debt taken on hastily or unnecessarily, which can set you back financially and harm your credit. This type of debt may be used to buy items that decrease in value, and may carry more risk, charge high interest and lack tax benefits. Here are some examples of bad debt, and why it’s bad:
- High-interest credit card debt: The average credit card APR is 24.04%, and Americans owe $1.233 trillion in credit card debt. Credit cards are often used to buy consumer goods, travel packages, holiday gifts and other purchases that don’t appreciate in value. Credit cards can be beneficial for building a credit history when used responsibly, but if you can’t pay off your high-interest balance, you could find yourself in a difficult financial situation.
- Other high-interest loans: Some loans may charge extremely high interest rates with payments that are difficult to afford. For example, typical payday loans may have an annualized interest rate as high as 400%.
Before taking on debt, it pays to consider whether it’s good or bad debt by looking at the purpose, terms, potential credit impact and your end goal for taking on the debt.
How to turn bad debt into good debt
If you have bad debt, don’t despair. With a bit of legwork, you may be able to turn your bad debt into good debt (or at least better debt). Here are several options.
Refinance or consolidate
Taking out a new loan to refinance or consolidate existing loans is a popular way to address overwhelming debt. In fact, almost half of LendingTree users seeking a personal loan intend to use it to pay down debt.
Refinancing or taking out a debt consolidation loan can lower your interest rate and simplify your payments. If you go this route, shop around for the best interest rate, choose a reputable lender and verify that the payment fits into your budget.
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Improve credit score
Taking steps to boost your credit score may help you qualify for a new loan with better terms and lower interest rates. In fact, a LendingTree study found that raising your credit score from fair to very good could save you more than $39,000 in loan payments.
Steps you can take to improve your credit score include:
- Set up automatic payments to make sure you pay your bills on time.
- Pay down debt to improve your credit utilization ratio, keeping it below 30% of your available credit.
- Improve your credit mix by strategically taking on new credit (like an auto loan) only when it makes sense for your financial situation.
It’s wise to monitor your progress by regularly checking your credit reports and tracking your credit score as it improves over time. Many credit card issuers offer free credit scores.
Use new credit strategically
Be wise about borrowing money to make sure any loan you take benefits your financial situation. One example: Taking on a home equity line of credit (HELOC) for renovations that can increase the value of your home, which may be your biggest asset.
The right debt can also help you to improve your mix of credit, which counts for 10% of your FICO Score. A higher credit score may help you to qualify for better terms on new credit, opening up your options for using debt strategically.
How to build a healthier debt mix
No matter what your situation, you can take proactive steps to change your financial picture and build a healthy credit mix.
Here’s how to go from bad debt to good debt:
- Audit your debts: Start by making a simple chart of all your debts. List the type of debt, balance, interest rate and minimum monthly payment. Crunch the numbers to determine the total of all your monthly payments. Then look at your budget and decide how much extra you can put toward your debt each month. (Keep in mind that with credit card balances, paying only the minimum can keep you stuck in debt for years.)
- Prioritize high-cost, high-interest balances: Decide whether each debt is good or bad, then rank your debts from worst to best based on the interest rates and balances. Pick a debt repayment strategy (e.g., the snowball method or the avalanche method) and begin applying the full extra monthly amount to a high-cost debt. If you’re overwhelmed, keep in mind that you have many debt relief options.
- Refinance or consolidate when it saves you money: Consider refinancing or consolidating your debt if it makes sense in your situation. For example, a LendingTree study found that refinancing a mortgage could save over $50,000. Or, if you have one or more high-interest credit cards, it may benefit you to apply for a consolidation loan or transfer your balance to a zero-percent credit card with an introductory interest rate.
- Keep your credit use in check: Take a look at what got you into bad debt in the first place. Identify any patterns or issues that contributed, so you can make changes to avoid building up bad debt again. For example, if unexpected emergencies — like a car breakdown or busted hot water heater — caused you to reach for a credit card, start an emergency fund.
- Revisit your credit mix yearly: Once you’ve got a debt repayment plan in place, audit your debts each year. Take a look at your credit mix and determine whether any new debt you’re considering would improve your overall financial picture. Benefits of some types of debt may include a boost to your credit, tax advantages or an increase in your overall financial health. Keep in mind everything you’ve learned about the difference between good and bad debt whenever you think about taking on any new debt in the future.
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