September 12, 2024 |8 min read
A key difference between good debt and bad debt is whether the money borrowed positively affects your financial health. When managed responsibly, debt can be helpful. But the opposite is true too.
You might think of it like this: Good debt offers long-term financial benefits. Bad debt with unmanageable payments and ballooning interest could lead to negative consequences.
What you’ll learn:
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Debt can be good or bad.
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Debt used to help build wealth or improve a person’s financial situation might be considered good debt.
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Debt that’s unaffordable or doesn’t offer long-term benefits might be considered bad debt.
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Debt that might be considered good has the potential to become bad if it’s not managed responsibly.
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What is good debt?
Good debt might refer to loans or credit that helps you manage everyday expenses or reach financial goals. Goals might include owning a home, paying for school or starting a business. Debt might also be considered good if it helps you increase your assets or build credit by managing it responsibly.
But part of what separates good debt from bad debt is how it’s managed. This means using credit responsibly, like making monthly payments on time.
Loans and credit cards can also help open new doors and opportunities, but there are no guarantees. Any debt you can’t pay back on time could be considered bad.
Examples of good debt
Here are some types of debt that can be considered good debt under the right circ*mstances.
Keep in mind, though, that any type of debt could potentially become bad debt in different circ*mstances—if you can’t repay it on time or it negatively affects your credit scores, for example.
Mortgages
Monthly mortgage payments build equity, which could lead to a higher net worth. And interest paid on a mortgage can sometimes be tax deductible. But mortgages can be complicated, especially adjustable-rate mortgages. The Consumer Financial Protection Bureau says to “make sure to read the terms carefully and ask lots of questions until you understand exactly how each of these features of the mortgage works.”
Student loans
Financing education can be necessary to get a degree, which has the potential to increase earnings. Student loans typically have lower interest rates compared to other lines of credit. Plus, the interest can be tax deductible. It’s important to remember that student loans also have the potential to create a long-term burden. But the Federal Deposit Insurance Corporation has tips and guidance that might help avoid that.
Personal loans
A personal loan can be helpful for consolidating debt at a lower interest rate. And if it’s an unsecured personal loan, you may not need collateral—like your home—to secure the financing. But personal loans can take many forms. Check the section below to learn about examples that might be considered bad.
Auto loans
A car can provide valuable transportation or help someone get to a job—which could lead to increased earnings. In that way, an auto loan could represent good debt. But there’s a lot to consider that could strain finances and make an auto loan a burden. Working things like the down payment, loan term and interest rates into your budget might help you determine whether a car loan is a good idea.
What is bad debt?
Debt might be considered bad if it’s difficult to repay or doesn’t offer long-term benefits—think loans with high interest rates or unfavorable repayment terms, for example.
If you’re considering taking on debt, it might help to consider what it could do to your debt-to-income (DTI) ratio. Your DTI ratio is what you earn relative to the debt you owe. If you’re taking on a debt with a monthly payment that is beyond what you earn each month, it could make it hard to pay back. That may be a sign it’s not the right move.
Examples of bad debt
Here are a few types of debt that might be considered bad.
Debt you can’t afford
Debt you aren’t able to pay back on time might be considered bad debt. For example, a home purchase could be a good buying decision for someone who has the income to make their monthly mortgage payments. And a mortgage might ultimately improve their credit. But borrowing money to buy a home wouldn’t be considered good debt if the purchaser isn’t able to make consistent, on-time payments over the life of the loan.
Payday loans
Payday loans are generally short-term, high-interest loans, often without requiring a credit check. These types of loans can have higher interest rates, and you usually have to pay them back by your next payday.
Payday loans usually don’t get reported to any of the major credit bureaus. That means even if you do make on-time payments, your credit scores probably won’t reflect it. But if you fall behind on payments and the debt is sent to collections, that could show up on credit reports.
Debt that negatively affects your credit scores
Debt that affects your credit scores in a negative way is an example of bad debt. This can even happen to a previously good debt if it isn’t responsibly managed—say, if you fall behind on payments or if your credit utilization ratio goes too high.
Are credit cards good or bad debt?
Like any debt, how you manage credit cards helps determine whether they might be good or bad. But in general, there are a few key differences that separate good and bad credit card debt.
Credit cards as good debt
With responsible use, you can use credit cards to build credit. And good credit can help you when you go to borrow money, finance a car or rent an apartment.
Credit cards can also give you the flexibility to do things like finance large purchases and consolidate debt. And using a promotional APR can help to keep interest charges down.
Using a rewards credit card can also offer cash back or miles for everyday purchases, which can reward you for things you’re buying anyway.
When credit cards could lead to bad debt
When a cardholder pays off credit cards in full every month, there’s no interest accruing on new purchases. But when a cardholder carries a balance from month to month, credit card debt can build over time.
How to avoid bad debt
Debt happens. It’s what you do with it that determines whether debt could be good or bad. And while it’s not always possible, it can help to figure out whether the debt you’re taking on is something you can actually afford. Here are some tips to help:
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Review your possible monthly payment. Would this new bill be something you can realistically afford?
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Look at the interest rate. The lower the interest rate, the less interest you could pay over the life of the loan.
- Think about your long-term goals. Will borrowing this money help or hurt you in the long run?
Good debt vs. bad debt FAQ
If you’re still learning about what separates good debt from bad, these frequently asked questions might help.
What is the difference between a loan and bad debt?
This may not be the right question. Like any debt, a loan could be good or bad. It all depends on how it’s managed, or how it affects the borrower’s finances and long-term outlook.
How can good debt turn into bad debt?
There are some types of debt that may generally be considered good. But any debt can become bad debt if it’s not managed responsibly.
Does bad debt ever go away?
According to the Consumer Financial Protection Bureau, “a debt doesn’t generally expire or disappear until it’s paid.” But bad debt’s impact on your credit might eventually go away. You can read more about what affects credit scores and how long derogatory marks stay on credit reports.
Key takeaways: Good debt vs. bad debt
Debt can be good or bad. In general, good debt helps improve a person’s financial situation. Debt that’s hard to manage and hurts a person’s finances might be considered bad.
Credit cards might be considered good debt if you’re able to use them responsibly to handle expenses and build credit. You can compare Capital One credit cards and check if you’re pre-approved without harming your credit.
