Good Debt Vs. Bad Debt: Understanding What You Owe
It’s funny how people use words. Qualifying for credit is seen as a good thing. Being in debt is seen as a bad thing. The truth is, they amount to much the same thing — borrowing money to spread expenses over a longer period of time.
But is such borrowing a wise financial move?
Think of debt as a tool, like a hammer. You might use a hammer effectively to drive home a few well-placed nails, or you might carelessly hit yourself on the thumb and carry a nasty welt with you for some time. In other words, whether the debt is good or bad largely comes down to how you use it.
What is considered good debt?
While all debt should be used carefully and in moderation, the following are six types of debts that generally have characteristics favorable to consumers.
1. Student loans
Student loans are often considered good debt because of their relatively low-interest rates plus their borrower-friendly repayment terms. However, it is important to note that these positive characteristics relate primarily to federal student loans, which have an initial grace period after you leave school before payments start, multiple repayment options, forgiveness programs, and options for postponing or suspending payments.
Beyond that, one characteristic of good debt is that there should be a lasting benefit beyond the length of the loan. Ideally, those student loans help you get an education that improves your earning potential. So choose your educational program wisely (as well as how much you borrow) so you come out of school with a marketable degree or other credentials.
2. Real estate purchases
According to Bruce McClary, vice president of communications for the National Foundation for Credit Counseling (NFCC), carefully chosen mortgages are considered a healthy form of debt “because of a combination of competitive interest rates, low fees and the chance to build equity as the loan balance is paid down while the value of the collateral increases.”
Note, however, that not all mortgages meet McClary’s criteria. It is important to shop around for a home loan with competitive fees and interest rates. In terms of the opportunity to build equity, this depends on buying a home as a long-term decision at a reasonable price, rather than viewing it as just a kind of short-term speculation.
Also, adjustable rate mortgages introduce an added element of risk to a home loan. While they may carry lower payments initially, there is the possibility that those payments might rise over time, and perhaps even become unaffordable. So, a purchase mortgage is often a good form of debt, but only if it is affordable both now and over the life of the loan.
3. Home improvements
Taking out a home equity loan to pay for home improvements has much the same value as a mortgage: It can be good debt if the interest rate and fees are competitive, the payments are affordable and the benefit of the improvement either exceeds or outlasts the debt.
If you are making improvements with an eye toward raising the resale value of the home, be advised that relatively small improvements, like attic insulation or replacing the front door, tend to pay off better than major projects like a room addition, according to the 2017 Cost vs. Value report from Remodeling magazine. If you plan on staying in the home long-term, energy-efficiency improvements can pay off by lowering your utility bills. The federally sponsored Energy Star website has guidance on evaluating the energy efficiency of your home and figuring out how you can lower utility bills.
Again, a rule of thumb for distinguishing good debt from bad is that the purpose of the debt should have a benefit that lasts beyond the repayment term of the loan. The right home improvements can certainly meet this test.
4. Short- to medium-length car loans
Personal transportation is essential in many areas of the country, so car loans are very common. They can also be relatively cost-effective. According to the Federal Reserve, the average rate on a five-year car loan as of late 2017 was 4.36 percent, considerably less than the typical interest rate on credit cards or personal loans. Note that rates vary greatly from lender to lender, so the cost-effectiveness depends on getting a competitive rate.
One key is to keep the term of the car loan reasonably short — recommends car-comparison shopping site Edmunds. This helps reduce your interest charges and increases the chances that the useful life of the car will outlast the loan. For the latter reason, loans on used cars should generally be shorter than those on new cars.
5. Temporary credit card balances
The emphasis here is on the word “temporary.” A credit card can be a convenience that is more secure than carrying cash and can offer you added benefits such as rewards or protection on certain purchases. Using a credit card responsibly can also help you build credit, which can help you get favorable terms on other loans in the future.
Those are very worthwhile characteristics if you avoid finance charges by paying your balance off in full each month. Or, if you’re using a credit card with a promotional 0 percent APR, it can be a smart way to make a large purchase. The bottom line is that credit cards are designed to be short-term debt, so make sure you use them that way.
6. Personal loans
A personal loan can be a smart alternative to credit card debt because on average personal loans carry lower interest rates than credit cards and have a defined repayment period.
As with other forms of debt though, the value of a personal loan depends on the details, such as getting a competitive interest rate with low or no fees, choosing a repayment structure you can afford and use the money for something with long-term benefits.
What is considered bad debt?
The following are some forms of debt that can be bad for you because they are not cost-effective and/or they lead to problems with handling debt. You should notice that some forms of credit, namely credit cards and car loans, appear in both the “good debt” and “bad debt” sections of this article. The difference is a matter of how you employ these tools.
1. Lingering credit card balances
As noted previously, credit cards are fine if you pay them off promptly, but they turn into bad debt if you regularly carry a balance.
For one thing, credit card debt is very expensive. According to the Federal Reserve, the average credit card balance incurs an interest rate of 14.87 percent (as of late 2017) and people with poor credit may find themselves paying considerably more.
If lingering balances represent bad debt because of the cost, continually growing balances spell even worse trouble. The NFCC’s McClary considers “running out of available room for new charges on a credit card” to be a classic warning sign that debt is getting out of control. This can lead to added finance charges if you are late making payments, and can make credit more expensive in the future if you damage your credit rating because of having excessive debts and late payment issues.
2. Long-term car loans
Car loans of five years or less can make a great deal of sense, especially for a new vehicle. However, choosing a longer-term car loan can raise some troublesome issues.
For one thing, extending a car loan beyond five years means you may have little if any gap between paying off the loan and having to buy a new car. That could limit your ability to pay for repairs on an older vehicle as well as build up a down payment and qualify for financing on your next vehicle. That ongoing car payment could also make it harder for you to save money for other things.
Also, the interest expense on a car loan rises sharply when you extend the term. calculated that six-year car loans tend to have three times the total interest expense that five-year loans do, due to higher interest rates, longer repayment periods and the tendency of people who take out longer loans to also opt or lower down payments.
3. Long-term loans with short-lived benefits
To piggyback on the theme of not extending your car loan out over the useful life of the vehicle, you should think long and hard about signing up for any loan that will take considerably longer to repay than the time span of your purchase. For example, even a relatively cost-effective form of borrowing like home equity can be more trouble than it’s worth if used for something as short-lived as a vacation.
Taking on long-term debt to finance short-term purchases means you are spending money faster than you can make it, and that is often a sure sign you are on the road to debt problems.
4. Car title loans
Car title loans are short-term loans that use your car as collateral. According to the Center for Responsible Lending (CRL), the typical annual percentage rate (APR) on car title loans is 300 percent. Between that excessively high APR and the tendency of these loans to lead to a cycle of repeat borrowing, the CRL found that the average car title loan borrower ends up paying $2,142 in interest for $951 worth of credit, and one in six of these borrowers faces repossession due to repayment difficulties.
5. Payday loans
Payday loans share many of the negative characteristics of auto title loans. “Interest rates and fees on these financial products have been known to double or triple the amount borrowed over the life of the loan,” says the NFCC’s McClary.
This type of borrowing is likely to get you into trouble. If you cannot make ends meet this week, how are you going to do so next week when you have those heavy finance charges on top of your usual expenses?
6. 401(k) loans
People who have built up a decent balance in their 401(k) plans are often tempted to draw upon those balances in times of financial need. After all, what could be wrong with borrowing from yourself?
As it turns out, acting as both borrower and lender can hurt you on both ends. As a borrower, you will be expected to pay back the loan with interest, and if you fail to do so any unpaid amounts may be considered a nonqualified distribution from the plan. This means you will face paying income tax on those amounts plus a 10 percent penalty. Many 401(k) plans require loan balances to be repaid immediately if the employee leaves the company, which could create an added financial burden at the worst possible time.
From the point of view of the lender, the interest you repay may be below the investment returns you would have been able to earn by leaving those assets in the financial markets. Also, if repaying the loan causes you to skimp on your regular 401(k) deferrals, your retirement savings will suffer.
What many of the above have in common is that they seem like readily available sources of credit you can turn to in a crunch, but they have long-range consequences. The most important thing about a loan is not how easy it is to get, but how easy it is to pay off. McClary from the NFCC warns in particular against loans that “are issued without a complete assessment of a borrower’s ability to repay, which sets the stage for delinquency and the accrual of even more fees.”
How to turn your bad debt into good debt
If you have already taken on some bad debt, there may be ways to convert it to good debt. You can accomplish this by achieving some or all of the following goals.
- Lower your interest rates. Shifting high-interest debt like a credit card balance into lower-interest debt like a personal or home equity loan can save you money. You could also look into credit cards with lower interest rates or promotional 0 percent APR period that allow you to reduce the rate you are paying as you work to pay off the debt. Watch for balance transfer fees and pay attention to promotional APR terms before moving balances between credit cards.
- Organize payments. If you’re juggling a mortgage, student loans, a couple of car loans and a handful of credit cards, it can be hard keep track of all your payments. Consolidating some of that debt into a loan from a single source can simplify your repayment schedule and make it easier to stay up to date.
- Make payments affordable. Though not ideal, refinancing debt to extend the repayment period can make your monthly payments more affordable. While the longer repayment period is likely to raise your overall interest charges, it may be your best option if this is the only viable alternative to default and if it gets you on track to get out of debt.
Shifting debt around may accomplish the above goals, but it doesn’t solve the problem unless it is part of a comprehensive program to steadily reduce and eliminate debt over time. Otherwise, McClary cautions that “borrowing from one account to make payments on another” can be a warning sign that your debt is getting out of control.
Debt is both a valuable financial tool and a source of heartache for too many Americans. This is why there can be both good debt and bad.
To use debt responsibly, think about both the present and the future when you borrow:
- For the present, think about the right type of debt to take out for your needs, and shop around to find the cheapest source of that debt.
- For the future, think about how you will feel about this debt when you are still repaying it in the years ahead. Avoid obligations you think you might regret later on.
Just because debt can get people into trouble doesn’t mean you should have to swear off it altogether. Thinking in terms of what is good and what is bad debt should help you make your borrowing decisions responsibly.