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What’s the Difference Between Good Debt and Bad Debt?
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Debt has such a negative connotation that it’s hard to imagine that it can be good for your financial well-being. But mortgage debt and student loan debt allow you to invest in real estate and increase your earning potential, and an auto loan that is borrowed responsibly helps you afford the car that you need to get to and from work.
However, some types of debt are better than others, and too much debt is never a good thing. Learn the differences between good debt and bad debt so you can make informed financial decisions when you need to borrow money.
Good debt vs. bad debt: What’s the difference?
Not all types of debt are inherently bad. But the way you manage a debt and its terms can make it good or bad. Debt that helps you achieve your financial goals in a responsible way can be considered good debt. Debt that works against your financial goals and takes away from your ability to get ahead financially is bad debt.
Some examples of good debt are mortgages, student loans and debt consolidation loans. Bad debt comes in many forms: revolving credit card balances, payday loans and any other type of secured or unsecured loan with unfavorable terms.
6 types of good debt
1. Mortgage debt
Financing a home purchase isn’t just healthy debt, it can be a smart investment in real estate that can earn you money in the long run. Homes typically appreciate in value which gives you the opportunity to build equity, especially if you live in a booming area. Plus, mortgages tend to have lower interest rates than other kinds of debt.
2. Auto loans with short- to medium-length terms
Unlike your home, your car depreciates in value over time. When you take out a loan to finance your car, it’s best to avoid long-term auto loans that cost more in interest over time and take longer to pay down as your car loses value. In general, you should follow the 20/4/10 rule for your auto loan:
- You should put 20% down toward the cost of the loan.
- Your auto loan term should not exceed 4 years.
- You should keep transportation costs below 10% of your budget.
Auto loans within these parameters are considered good debt. Use this auto loan calculator to see an estimate on how much you can afford.
3. Student loan debt
Going to college or trade school can be an investment in your future earning potential. People who attain a degree in higher education have higher pay and lower rates of unemployment.
Federal student loans have relatively low interest rates as well as forgiveness programs, payment adjustments based on income and other unique financing benefits. However, private student loans may not come with the same perks.
|Federal student loans vs. Private student loans|
|Federal student loans||Private student loans|
|Definition||A student loan issued and guaranteed by the Department of Education||A private loan used for higher learning expenses that’s issued by a bank, credit union or other lender|
|Interest rates||Fixed interest rates||Fixed or variable; dependent on the borrower’s credit|
|Default period||If you can’t pay your loan, you default after 270 days||If you can’t pay your loan, you default after 120 days|
4. Credit card debt you pay off every month
Credit cards come with notoriously high interest rates, but you won’t pay interest as long as the statement balance is paid off in full every month. This gives credit card users the opportunity to earn rewards like cash back, travel miles and other incentives just for using the card and paying it off on time every month.
Plus, some credit cards offer promotional 0% APR financing, which allows cardholders to make purchases without paying interest for a set number of months as long as the balance is paid off by the time the period ends. Be careful, though: You may end up paying deferred interest on any balance that’s not paid off by the end of such a promotional period, depending on the card.
5. Personal loans with good terms
Personal loan interest rates can be as low as 3.99%, but they typically fall somewhere within the 10% to 25% APR range for good- to excellent-credit borrowers. That makes them a particularly useful tool when you want to refinance high-interest debt or cover a necessary cost.
Consumers who have a lot of high-interest debt, such as credit card debt, could consider consolidating and refinancing with a personal loan for debt consolidation. By securing a lower APR, borrowers could potentially save a lot of money in the long run, as well as benefiting from fixed payments and a fixed repayment term.
Personal loans can be used well in a number of circumstances. For instance, you could use a personal loan for a home improvement project that boosts the value of your home. Or you can use a loan as an alternative to a credit card when covering a large expense, since interest rates can be lower.
6. 401(k) loans
A 401(k) loan lets you borrow from your own retirement savings rather than a lender, making it a viable option for people with subprime credit or no credit. It also means that interest rates are lower than what you would pay with a lender (typically prime plus 1%). And you’ll be paying interest back to yourself, which makes this a much less costly way to borrow than other alternatives.
However, borrowing from retirement will inhibit your 401(k)’s growth, which will cost you a lot of money in the long term, and you might be subject to an early withdrawal penalty if payments aren’t made on time. Plus, you risk having to pay back the loan within 90 days if your employment is terminated.
4 types of bad debt
1. Credit card debt you carry from month to month
The average APR across all open credit card accounts in May 2020 was 15.09%, according to data from CompareCards. For new card offers, it was 19.21%. That can be a high price to pay for flexible financing.
When you carry a balance on your credit card from month to month, you’re paying high interest on everyday purchases you made on your card. The cost of financing everyday items like groceries or clothes can be astronomical, making credit card debt one of the worst types of debt you can carry.
|Paying off $1,000 in credit card debt|
|Length of repayment||4 years, 8 months|
|Total interest paid||$395|
|The calculations above assume the cardholder only makes the minimum payment.|
2. Long-term auto loans
Since your car depreciates over time, a long-term auto loan essentially guarantees that your car will lose value faster than you can pay off the loan. The longer you’re paying off the loan, the longer it takes you to have any equity in your car since you’re paying more toward interest every month.
You can even end up with negative equity, which is when you owe more than your car is worth — meaning if you want to trade in or sell your car, you’ll actually owe money when you’re ready to upgrade to a new ride. Owing more money on the loan than your car is worth is also called being underwater or upside-down on your auto loan.
Long-term auto loans tend to have higher APRs than short-term auto loans, meaning you’ll spend more money in interest payments with a longer loan. However, a longer auto loan may work better for borrowers who want lower monthly payments.
3. Personal loans with bad terms
Like any other financing tool, personal loans can be used well or poorly. It’s important to shop around so you can get a fair deal on a loan for your financial situation. A personal loan with a high APR will cost much more over the life of a loan compared with a personal loan with a reasonable APR. See this example:
|The cost of a $5,000 personal loan: Good credit vs. fair credit|
|Terms||Good credit (760+)||Fair credit (640-679)|
|Loan amount and length||$5,000 over 3 years||$5,000 over 3 years|
|Average best offered APR*||11.81%||24.89%|
|Total cost of loan||$5,962||$7,146|
|Amount paid in interest||$962||$2,146|
|Source: LendingTree Personal Loan Offers Report, May 2020|
Because personal loans are unsecured and backed by your promise to repay the lender, personal loan lenders look closely at your credit history and income to determine your eligibility as a borrower. Subprime borrowers with credit scores below 640 will get less favorable terms on a personal loan. If this is your case, it might be best to consider alternative financing options.
4. Payday loans
Payday loans are a quick way for people with bad credit or no credit to get small amounts of funding, typically up to $500, in an emergency. But they’re loaded with high APRs and predatory terms, because the lender can garnish your next paycheck if you don’t repay the debt. When you take out a payday loan, you end up paying significantly more than the money you borrowed. Your average two-week payday loan can come with nearly 400% APR, according to the Consumer Financial Protection Bureau (CFPB).
How to lower your bad debt and boost your good debt
Refinance or shop around for lower APRs
When searching for financing, the APR is one of the most important factors you’ll want to look at. It reflects the total amount you’ll pay over the course of the loan. The higher your APR, the more you will pay the lender or bank over time. Refinancing or shopping around for a lower APR can save you money in the long run.
If you’re hanging onto old debt from when you had a lower credit score and your credit has since improved, then you should refinance your debts as soon as possible. It’s also smart to refinance your mortgage and other loans when interest rates are low.
Refinance to pay off your loan faster
The longer the loan term, the more you’ll pay in interest over time. If you can afford to contribute more toward debt repayment every month, consider making higher payments or refinancing to a shorter loan length. See the difference in interest paid between a six-year auto loan and a three-year auto loan in the table below:
|The cost of a $15,000 auto loan: 3 years vs. 6 years|
|Terms||3 years||6 years|
|Average auto loan APR*||4.21%||4.45%|
|Total cost of loan||$15,993||$17,119|
|Amount paid in interest||$993||$2,119|
|*Source: ValuePenguin data, May 2020|
Don’t take on more debt than you can afford
When you have more debt than you can keep up with, it’s hard to save up money and get ahead financially. This is particularly true with credit card debt: Don’t charge your credit card more than you can pay off every month. Your debt should not exceed 36% of your pretax income, according to Charles Schwab, the financial services company. This includes your mortgage, auto loan, personal loans and any other types of debt you may have. As long as you keep your debt in check and shop around before choosing a creditor, you’re setting yourself up to succeed financially.