Good Debt vs. Bad Debt: What’s the Difference?
The topic of debt can be as polarizing as politics. Some people think debt should be avoided at all costs, while others believe in using every opportunity to leverage OPM (other people’s money).
But debt isn’t a cut-and-dry issue. It’s often divided into two categories: good debt and bad debt. Good debt can help you achieve your financial goals faster and improve your finances, while bad debt can work against you financially.
We’ll look deeper at good debt vs. bad debt so you can understand the difference and be a well-informed consumer.
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What is the difference between good debt and bad debt?
Debt is money owed to someone else, but not all debts are equal. Consumer debt is considered either good or bad based on the purpose of the debt, repayment terms and other factors. An individual’s financial situation, as well as how they manage the debt, also determine whether a debt is good or bad for them.
|Good debt||Bad debt|
|Used on items that appreciate||Used on items that depreciate or are unnecessary|
|Low interest rates||High interest rates|
|Can impact your finances positively||Can impact your finances negatively|
What is good debt?
“Good” debt can improve your financial situation by increasing your earning potential or net worth. In addition, debts with low interest rates and other favorable terms are considered good debt. Some common examples of good debt may be mortgages, student loans, small business loans, some auto loans and some personal loans.
Real estate typically appreciates over time, and owning a home helps build wealth. According to the Federal Reserve, the average net worth of a homeowner is about 40 times the net worth of a renter.
Since plunking down cash for a home isn’t a reality for most people — a report from the National Association of Realtors shows 78% of recent buyers financed their home purchase — taking out a mortgage can help you get into the real estate game. In addition, mortgages have lower interest rates than most other types of debt.
Of course, there are always exceptions — be wary of predatory mortgage terms or buying a home you can’t afford.
Taking out student loans to invest in your education is considered good debt. Higher education can increase your earning potential and career prospects — plus, student loans have relatively low interest rates.
When taking out loans, however, borrowers should be wary of private student loans; they have higher interest rates and fewer protections than federal loans. Consumers should also be cautious about how much they borrow — a standard guideline is to limit your total student loan debt to your expected first-year salary.
Small business loans
For entrepreneurs and small business owners, taking out a small business loan to invest in their company can be a wise choice.
However, the terms on small business loans can vary greatly. Stick with loans that have low interest rates and short repayment periods, and invest the funds in appreciating assets or growing your business.
Short-term auto loans
Car loans are a reality for many consumers — especially considering the high prices of used and new cars. However, a car is a depreciating asset; it’s best to keep the financing to short-term loans, so you can avoid making monthly payments on a vehicle that’s lost most of its value. One guideline to consider is the 20/4/10 rule:
- Put at least 20% down
- Choose a term of four years or less
- Keep total transportation costs within 10% of your monthly net income
Personal loans with good terms
The interest rates on personal loans can vary significantly — some as low as 6% and others reaching into the high double digits. As such, personal loans with favorable terms (reasonable interest rates and short repayment terms) can be considered good debt.
Another factor to consider is the purpose of the loan. For example, using a low-interest personal loan for debt consolidation of high-interest debt can be a wise strategy, while using it to buy a new TV wouldn’t be a smart move.
What is bad debt?
Generally, any debt that has a negative impact on your finances is bad debt. This can include debt used to purchase items that depreciate or have no value (like food and clothing), loans with poor terms or obligations you struggle to pay.
Credit card debt
Using credit cards can be an expensive way to borrow money, with the average interest rate on new credit card offers hovering close to 24%. Consumers often use credit cards to purchase clothing, electronics, food, vacations and other consumable items, which means paying interest on things that lose — or never possessed — tangible value.
However, some consumers pay their credit card balances off every month without incurring interest. In this case, credit cards can provide convenience or a way to accumulate points and rewards without sinking you deeper in debt.
Desperate consumers turn to short-term payday loans when they can’t secure other financing options. However, the fees on typical payday loans — also called cash advance loans — are equivalent to paying close to 400% APR, making them one of the most expensive ways to borrow money. Plus, getting out of the payday loan cycle can be challenging.
Generally, payday loans should be avoided at all costs. If you already have payday loan debt, there are programs to help with payday loan consolidation.
High-interest personal loans
While it can be beneficial to leverage low-interest personal loans strategically, high-interest loans are considered bad debt. Depending on your credit score, interest rates can reach high double digits, making them a poor financing choice — especially when used on items that don’t increase in value.
Long-term auto loans
Cars are depreciating assets, so taking out a long-term auto loan means you’ll be paying off the vehicle long after it’s lost a significant amount of its value. In addition, the longer the term, the higher your interest rate will be. When taking out a car loan, opt for a shorter repayment period — as long as you can afford the payment.
Any debt you can’t afford
Taking on too much debt — good or bad — can hurt you financially. If you borrow a significant amount of money in proportion to your income, struggle to pay the debt or the monthly payments leave you no room to save and meet other financial obligations, you’re likely overextending yourself.
How can I avoid bad debt?
In addition to steering clear of bad or predatory debt, you can take steps to ensure the obligations you take on remain in the “good debt” category.
Shop around for lower APRs
Before committing to a loan or credit card, you’ll want to pay close attention to the annual percentage rate (APR). Loan interest rates and APRs (which account for the loan’s interest rate plus additional fees) play a significant role in the cost of the loan. A higher APR means you’ll pay more in interest over the life of the loan.
To find the lowest loan rates, compare APRs from multiple lenders, and also consider looking at different types of lenders. For example, auto loans from credit unions may have lower APRs than traditional banks and finance companies.
Refinance to repay your loan faster
Refinancing existing debt can make sense for many reasons. If you refinance a loan to a shorter term, you’ll pay the debt off faster and may receive a lower interest rate. In addition, if interest rates have dropped since you took out the loan or your financial situation has improved, refinancing to a lower rate will reduce the total cost of the loan.
Even if you don’t end up refinancing, you can pay more than the minimum payment to pay down the debt faster.
Select short-term loans
Opting for shorter loan terms when taking out a loan has multiple benefits. Not only will you pay the debt off faster, but you’re also likely to receive a lower interest rate and pay less interest over the life of the loan. Of course, having a shorter loan term means your monthly payment will be higher, so you’ll need to make sure you can afford the larger amount.
Improve your credit score
Your credit score is another factor that can determine whether a debt is good or bad. Lower credit scores result in higher interest rates, which means you’ll pay more in total loan costs.
Before applying for a loan or credit card, try to improve your credit score by making on-time payments or paying down some of your existing debts to lower your credit utilization. If you have loans that you took out when your credit score was lower, consider refinancing when your score has improved.
Build an emergency fund
Consumers often turn to credit cards, personal loans and other financing options to handle emergencies or unexpected expenses. One way to avoid the good debt vs. bad debt dilemma is to build an emergency fund.
The general rule of thumb is to have three to six months of expenses in a rainy day fund, but in some cases, saving even more may be necessary. Squirreling away that much can seem daunting if you’re starting from scratch, but tackling it in small chunks — like $500 increments — will make it more manageable.