Good debt vs. bad debt: Understanding the difference
The average American held over $101,000 in debt by the end of 2022, which is almost a 6% increase from the previous year, according to data from Experian. While debt often carries negative connotations, not all debt is created equal. In fact, taking out debt can be a short-term cost to long-term wealth.
The role of debt in personal finance
There is no official rule dictating the difference between good and bad debt. That said, good debt is debt that is used to bring you closer to your financial goals, while bad debt hampers your progress. You can leverage good debt, like your mortgage, to build wealth and secure your financial future. Conversely, the money you spend on bad debt is gone.
What defines good debt?
Characteristics of good debt
While not an official designation, good debt is any money you borrow to make more money. Bruce McClary, a credit counselor and senior vice president of membership and communications at the National Foundation for Credit Counseling says that good debt can be used to "invest in an asset with the potential to increase in value over time, generate income, or provide some other long-term financial benefit."
Mortgage
A mortgage is probably the largest debt you'll own. However, it is considered a good debt because it has some of the lowest interest rates and a high return on your investment.
Each time you make a monthly payment on your mortgage, you build equity on your home. Your home may also appreciate in value, increasing your net worth. You can then use your home equity as collateral to fund other investments like purchasing more property in the form of a home equity loan or a HELOC.
Student loan debt
Education is almost always a safe investment. However, higher education is costly, and many take out student loans to fund their college education. While the return on investment on student loans isn't as clear-cut as having a home loan, data consistently shows that students who earned a college degree out-earned high school graduates who didn't attend college.
According to the US Bureau of Labor Statistics, college graduates earn about $500 more per week or $26,000 yearly than those with a high school diploma.
Business loan
Entrepreneurship is an increasingly popular endeavor and can be a very lucrative one. However, some ventures have high startup costs. So, lenders offer business owners loans to assist with business expenses.
The return on investment of taking out a loan for your own business may not be as reliable as taking out a loan for your home. However, its interest rates are generally reasonable, your business expenses may be tax deductible, and you may be able to recover the cost of your loan if your business is profitable.
What defines bad debt?
Characteristics of bad debt
"What some refer to as 'bad debt' is a type of debt that is used to purchase goods or services that do not provide any long-term financial benefit and often come with high interest rates and short repayment periods," says McClary. While good debts can accrue value, bad debts may even depreciate in value.
Credit card debt
"High-interest credit card debt is often considered 'bad debt' because it is typically used to purchase items that lose value over time, such as clothes or meals," says McClary.
Owning a credit card isn't inherently bad. For many, it's one of those necessary evils to make daily purchases or build credit. In fact, the number of credit cards in circulation in 2021 was over three times greater than the current U.S. population.
Some of the best credit cards can be an effective tool to accrue attractive perks like travel rewards and cash-back bonuses. You can find our guide to the best rewards credit cards here. However, it's easy to overuse your credit card and rack up a seemingly insurmountable level of debt, which is compounding on top of itself.
The average credit card interest rate as of April 5, 2024 was 21.59%,which quickly gets expensive when you carry debt from one month to the next. Not only will this debt get in the way of your financial goals, but it will also jeopardize your credit score. You may end up with a high credit utilization ratio or simply miss payments, resulting in delinquencies on your credit report.
Payday loans
Payday loans are small loans, typically around $500, with extremely high interest rates. They use a portion of your next paycheck as principal. They are usually for people who need money immediately, perhaps to pay off an unexpected cost like a medical bill.
You can easily find yourself in a cycle of debt if you don't make payments in the allotted time. In the 26 states where payday loans remain legal, borrowers can roll their debt over to the next month, often for a fee. The Consumer Financial Protection Bureau says that the typical fee for pushing a payday loan payment back 14 days is $15 per $100 borrowed.
State laws generally restrict how much a lender can charge for a payday loan. Many states set a maximum of $10 to $30 for every $100 borrowed, according to the CFPB. For instance, a two-week payday loan for $350 with a financing fee of $50 has a 372% annual percentage rate (APR).
Auto loans
Taking out a loan to purchase a car is generally considered a bad return on investment. Unlike your home, which increases in value over time, your car's value depreciates significantly as soon as you drive it out of the dealership. In the first year of ownership, your vehicle will drop about 20% in value from the purchase price and 15% each subsequent year, according to CARFAX.
That said, you can't recover the cost of your auto loan, and you'll lose money on interest payments, especially if you have a longer lease. You can sell your car once you no longer need it, but with depreciation, you won't see nearly as much money as you put into it.
Strategies for managing debt
Regardless of whether your debt is good or bad, you'll have to pay it eventually. Mismanaged debt can cause you to pay more than you needed to and can affect any future money you borrow.
Make your minimum payments
Defaulting on your debt can reflect poorly on your credit report, lowering your credit score and making any future borrowing far more costly. In the worst-case scenario, creditors can seize your assets. You want to ensure you can make your monthly payments at the minimum.
Minimum payments usually cover any interest accrued on your debt, so if you want to start digging into your balances, you'll need to pay more than just the minimum. You can maximize the efficiency of your payments using the debt snowball or avalanche payment methods.
Build an emergency fund
A medical bill or a car accident can be financially debilitating. Fortunately, you can stay one step ahead of large, unexpected expenses by building an emergency fund to avoid going into debt. Experts recommend saving three to six months of funds for emergency expenses.
Work with a credit counselor
If you struggle to manage your debt, consider working with a credit counselor. A nonprofit credit counseling agency can lay out a payment strategy with you, giving you some steps to gain control of your credit.
The role of interest rates
Interest rates can affect how much of an impact debt has on your personal finances. Right now, with interest rates being higher, carrying credit card debt can have a negative impact on your finances because you will be making larger payments each month which makes that debt more expensive.
How to handle debt in changing economic times
You may have to change your strategies for how you take care of your debt based on the economy. The smart thing to do is to pay your credit card debt off in full every month and lower the amount of debt you are in overall. This means thinking about whether it makes sense to get into debt at all right now, and how you can save and budget.
Need help paying off your debt? Check out our debt payoff calculator.
This article was written by Jennifer Streaks and Alani Asis from Business Insider and was legally licensed through the DiveMarketplace by Industry Dive. Please direct all licensing questions to legal@industrydive.com.
