good debt vs bad debt

Good debt is any debt that can be seen as an investment in your future, such as buying a house or getting an education, while bad debt can be seen as spending that won’t help you in the long run. 

Read on to get a better understanding of credit and good debt vs bad debt, and how knowing the difference can help you make the best plans for getting rid of both.  

What’s Good Debt? 

Good debt is debt that has a lasting, positive effect on your life in the long run. Typically, good debt is present in financial situations that are created to generate income and ultimately build wealth. This type of debt has a sole purpose: to make you a better, richer person.  

Here are some examples of good debt: 

Student Loan Debt 

Student loan debt is considered good debt because they are used to improve a person’s employment opportunities and earning potential. Here are some quick facts about student loans:

  • These loans are typically issued at low interest rates (especially federal student loans), and in some instances, the interest can be tax-deductible. 
  • They tend to have lower interest rates than many other loans. 
  • For many people from lower or middle-income households, going into this type of good debt is the only way to pay for higher education.  
  • Broadly, student loans are viewed more as an investment.  

But be careful! If the terms of the student loan are violated by the lendee, or repayments become irregular, student debt can transform into bad debt. 

To avoid this, careful consideration should be made when considering a student loan—particularly the amount of money borrowed. Many times, people can borrow more money than they can effectively pay back, putting them into a cycle of debt that is difficult to escape.  

Some experts say you should try to borrow only as much as you’d want to make in your first year after completing your education program. 

Mortgage Debt and Real Estate 

Owning your home or other property through mortgage debt is considered good debt because it can provide you with opportunities to either save or make money. Based on research done by Statista, 53% of American consumers think that mortgages are a good form of debt.1  

  • With a mortgage loan, a person could buy a home to live in now and then sell it years later at a profit. Or, the property can be rented out to tenants and generate steady income.  

Additionally, homeowners can avoid many fees and receive tax breaks that aren’t available as a renter. Commercial real estate, when leased to well-performing businesses, can also create a strong cash flow. 

Mortgages and Home Equity 

Mortgages can also position you to generate another source of wealth: home equity.  

Home equity is the difference between the fair market value of the property and the amount of the mortgage loan and is the portion of the property’s value that isn’t attached to the mortgage itself. It can also be considered the “amount” of the property that you own. Here are some key points to consider with home equity:

  • It’s important to note that equity is not a value that can be liquidated into cash. The $120,000 home you bought a few years ago that is now worth $200,000 does not mean there is a check for $80,000 somewhere waiting for you. 
  • The real advantage in equity comes from the ability to leverage its value for a loan. Secured by real estate, these loans are pretty easy to qualify for and are usually issued at a low rate.
  • Renovations, upgrades, and the simple passage of time can increase the market value of a home. During that same span of time, the size of the homeowner’s mortgage loan decreases as they continue to make regular mortgage payments. That means that the longer you own a property, the greater the equity can be.  
  • All that considered, these loans should be reviewed with the same care as a mortgage loan so that you understand how they work and how repayment can fit into your budget and not harm your credit.  

What’s Bad Debt? 

Bad debt is debt obtained by borrowing funds to purchase a depreciating asset or something that will neither increase in value nor earn any money. Debt can also be considered bad when it is attached to something that provides little to no return on the investment. When you carry a lot of it, bad debt will almost always have a negative impact on your overall credit score.  

Here are some more examples of this type of debt:  

Credit Cards (of Course!) 

It’s no surprise that having lots of credit card debt can be bad. With easy application processes and high interest credit card options, they are an easy financial trap to fall into. Here are some key points to remember:

  • Unless you are planning to pay off the credit card’s full balance at the end of every billing cycle, having a credit card is an expense that will greatly exceed your investment.  
  • Many credit card companies offer rewards or “cash back” programs that advertise some level of overall savings on your purchases as a “thank you” for using the card. Often, these incentives do little to offset the interest rates and payments on credit cards.  
  • The bottom line is that credit cards can rack up high-interest debt very quickly. And credit cards are not an easy thing to navigate. 

For the first time ever, credit card debt in 2023 just hit $1 trillion for Americans.2 If you’re currently dealing with unmanageable credit cards, there are ways out. You could consider a consolidation loan or even refinancing your credit cards onto a new card with a zero-interest introductory offer. This could help pay off your high-interest debt without worrying about accruing more.

Auto Loans (aka The Not-So-Bad Debt)

Every inch of road you travel makes the car less valuable than it was at the moment you purchased it! This is why they’re considered bad debt.

Although auto loans are bad debt by definition, they can also be considered good debt for a couple of reasons:

  • First, having a car means access to a reliable means of transportation, which could be critical in maintaining the career that funds your entire life.  
  • Secondly, since car loans are so common, many creditors don’t consider them as too high of a risk. 

If you have to consider an auto loan, the smartest move you can make is to find a loan with the lowest interest rate available (remember, those rates can be determined by your credit score and other factors).

And when you do find an auto loan that works for you, never missing payments will keep this bad debt looking good. 

Good Debt and Bad Debt: What Should You Pay Off First?

It’s a smart move to pay off any debt as soon as you can. Generally speaking, taking on debt should be done cautiously, and you should avoid bad debt whenever possible.  

If you have high-interest loans like payday loans, cash advance loans, or other bad credit loans, then those should probably be the focus. Since payday loans and other short-term options tend to carry high interest rates, it’s always best to start with options like payday loans.

Managing Both Good and Bad Debt

Most people have both good and bad debt, and managing them can be as simple as making their monthly minimum payments. Or you can go deeper by looking into debt repayment strategies. 

While most of may already know what minimum payment entails, some may not be aware of the different debt management or repayment strategies out there; here are a few examples:

StrategyDescription
Refinancing or ConsolidationRefinancing involves taking out one loan to pay off another for new terms, while consolidating involves taking out one loan to pay off multiple. The goal of both of these options is to get better repayment terms, lower interest rates, and in some cases be able to pay off the debt quicker.
Avalanche MethodThe avalanche method involves paying the highest interest rate credit account first, while maintaining the minimum amount due on your other debts.
The Snowball MethodThe snowball method focuses on paying your largest amount of debt first, while also making minimum payments on your other debt.
Prioritizing Debt Payment With Your BudgetAnother strategy you can use is to prioritize debt payments within your budget. While that may mean cutting down on certain spending, setting goals for your money can really help you pay off both good and bad debts.
Get Help From a ProfessionalA financial advisor or credit counselor is a trained professional that can help with all kinds of finances including debt. Whether it’s finding all your debts, creating a repayment plan, or negotiating with your creditors, experts can help.

FAQS

Can good debt, like student loans, turn into bad debt?

Yes, student loans are generally considered good debt because they can enhance earning potential. However, if repayments become irregular or the borrowed amount is too high relative to future earnings, student loans can negatively impact your financial health.

Are there any situations where credit cards can be considered good debt?

Typically, credit card debt is viewed as bad debt due to high interest payments. However, if managed responsibly and paid off in full each month, credit cards can offer benefits without deteriorating your financial health.

What role does the Federal Housing Finance Agency play in mortgages and home equity loans?
The Federal Housing Finance Agency (FHFA) oversees major participants in the U.S. housing finance system. If you’re considering a mortgage or home equity loan, understanding the guidelines and regulations set by the FHFA can be beneficial.

Is it possible to have too much good debt, like a home equity loan or student debt?

Yes, even good debt can become burdensome if it exceeds your ability to make monthly payments and are high interest loans. It’s essential to borrow within your means and consider your debt to income ratio and financial situation.

Where do personal loans stand?

Personal loans can be tricky because they can be used for all kinds of purposes, and how you use your personal loan will determine whether it is bad or good debt. For example, using a personal loan for school can be seen as good debt, while using a personal loan for shopping may be considered bad debt.

Final Thoughts From CreditNinja

CreditNinja wants you to know that every debt comes with some form of risk to both the borrower and the lender. This means that borrowing money should involve a lot of research, and you should know that there is a thing as too much debt. 

Whether it’s good debt, bad debt, or any other financial obligation, what matters most is your complete understanding of those risks. In order to effectively manage your repayment schedule, it’s crucial that you develop a solid plan to stay on track to keep payments steady and on time. 

References:

  1. Good debt vs bad debt: consumer perception U.S. | Statista
  2. Americans’ credit card debt hits a record $1 trillion | CNN Business

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