Bad Debt vs Good Debt: What’s the Difference?

Many people have a negative outlook on debt. Monthly payments can create financial unmanageability. Interest rates fluctuate. Lending criteria may be strict. These are all good reasons not to take on bad debt. This article will explain what that means and introduce you to good debt which can improve your net worth and credit score. Here are some key questions and concepts covered in this article:

• What is good debt, and how can it benefit you?
• Examples of good debt that can improve financial stability.
• How good debt can positively impact your credit score?
• What is considered bad debt, and why should you avoid it?
• Examples of bad debt that could harm your financial health.
• How to avoid bad debt and make smarter financial decisions.

Debt is a financial tool that can either help or hinder your financial well-being, depending on how it is used. Good debts are investments that have the potential to increase your net worth. Bad debts are liabilities with no growth potential. Both must be managed responsibly with careful budgeting and timely payments. Mismanagement can have long-term consequences.

What is good debt?

Good debt contributes to long-term financial growth. It’s characterized by low interest rates, long-term value, and wealth-building potential. Payments on this type of debt typically build equity or ownership that shows up on the asset side of the ledge.

Examples of good debt

Examples of good debt include mortgages, student loans, and business loans. Here’s how that breaks down:

• Mortgage Loans: Monthly mortgage payments cover a combination of interest and principal determined by an amortization schedule agreed to when you sign the loan agreement. The principal creates equity, making this good debt.
• Student Loans: Borrowing to continue your education creates a different type of asset. Knowledge increases your earning power and opens doors to better employment opportunities. Student loans are an investment, not an expense.
• Business Loans: Borrowing money to generate income and expand a business is considered good debt. Profitability is not guaranteed, but business loans can be a wealth-building tool if you use them properly.
• Auto Loans (for income): Automobiles start depreciating when you drive them off the lot. That would normally make them bad debt. Buying a work vehicle for income is the exception, provided it produces more than the purchase price.
• Other Good Debt Investments: Real estate, professional certifications, and other wealth-generating opportunities.

Can good debt help your credit score?

Lenders and credit card companies normally review credit scores before approving you for any type of debt. Good debt may also be collateralized by the asset you purchase, like a home in a home loan. Your payments on that debt can impact one or more of the five variables used to calculate your credit score. Those variables are:

1. Payment history
2. Amounts owed
3. Length of credit history
4. Credit mix
5. New credit history

Making on-time payments and minimizing your credit utilization can positively affect your credit score. Doing that consistently increases your credit history length. Applying for diverse types of debt, like auto loans and mortgages, improves your credit mix. Conversely, late or missed payments can lead to bad credit due to lower credit scores.

What is bad debt?

Bad debt is an expense, not an asset. You can’t build wealth with it because the interest rates typically exceed average rates of return. Any assets involved depreciate too quickly for wealth accumulation to take place. Bad debt is high risk with no reward. You’ll want to stay away from it if possible.

Examples of bad debt

• High-Interest Credit Card Debt: This is one of the more dangerous forms of bad debt. Most credit cards have variable interest rates (APRs) that can make it difficult to pay off balances. Many Americans get caught in this cycle.
• Payday Loans & Predatory Lending: Short-term, high-interest loans can trap borrowers in a cycle of debt. They’re intended for people who need cash immediately, but you pay a price for that. The price gets even higher if you don’t pay on time.
• Luxury Purchases on Credit: Financing non-essential items that depreciate is not a wealth building strategy. The value of the purchase should appreciate or at least remain constant for a major purchase to be considered good debt.
• Unnecessary Auto Loans: Buying a car beyond your means with expensive financing might put you in a nice ride, but it won’t do anything for your wallet. Auto loans are only good debt if the car can generate income.
• Personal Loans for Non-Essential Spending: If you need to borrow money for vacations, shopping sprees, or entertainment, you should probably refrain from making those purchases. Waiting until you have the cash is more prudent.

How to avoid bad debt

Accumulating too much bad debt can lead to credit score reductions and potential debt collections. You can avoid this by creating a sensible budget and avoiding unnecessary loans or credit card debt. It’s more cost-effective to build an emergency fund or basic savings account you can use when you have unexpected or “extra” expenses.

Use your credit wisely. You can do that by keeping balances low and paying credit cards in full each month. Read the terms and conditions closely so you understand what you’ll pay in interest and fees. If you’re already in debt, search for zero-interest balance transfer credit cards or debt consolidation loans with lower rates. Debt settlement may also be an option.

The bottom line

Understanding good debt vs. bad debt is a good first step to responsible financial management. We encourage you to research this further so you can make informed decisions. Two resources we can help you with are our articles on Managing Debt and Money Management. You can also search our blog to find other topics that might interest you.