What Is Good Debt Vs. Bad Debt?
PUBLISHED: Aug 26, 2021
The word debt often conjures a bogeyman of bad financial choices. While some debt is certainly bad, other kinds of debt can be considered good debt as a tool to help you on your financial journey. But what makes a debt good or bad? We’ll cover the difference between good debt vs. bad debt, and how they can both impact your finances, below.
What Is Good Debt?
Good debt is any loan that offers a return on investment, such as a mortgage. When you take out a loan to finance something that is expected to appreciate in value, and you’re able to pay that loan back while complying with loan terms, the loan is considered good debt.
Why Is Some Debt Good?
Not all debt is created equally. Some debt will hold you back from reaching your big goals. But other types of debt can actually help you achieve financial or personal milestones in your life, like buying a home or getting a college degree. We’ll cover a few examples below.
What Is Bad Debt?
Bad debt is debt used to buy noninvestment goods and services that usually don’t appreciate in value. Bad debt often accumulates on credit cards and is typically used to buy consumer goods that incur interest while the item itself loses or depreciates in whatever value it originally had.
Good Debt Vs. Bad Debt: Key Differences
Debt of all kinds can be a drain on your budget. But there are some key differences that separate good debt from bad:
- Good debt is any loan that finances a good or service expected to increase in value over time, while bad debt finances a good or service that will depreciate over time.
- Good debt will hopefully generate a return on investment, while bad debt can make you lose money.
- Good debt is a loan you’re able to repay, while bad debt is a loan you can’t afford.
- Good debt can become bad debt if poorly managed.
Examples Of Good Debt
Good debt is one that the borrower has planned for and can afford. Big ticket items like vehicles, work equipment and housing are needs that will likely require some level of debt. These purchases usually fill a vital need for your lifestyle or career choice.
Mortgages
Most adults will spend a large portion of their income on their homes. Mortgage, utilities, renovations and general maintenance are all a part of the cost of living. Mortgages pay for shelter that could appreciate in value over time (though this is never guaranteed). Plus, the homeowner would have to pay to keep a roof over their head whether they rent or take out a home loan.
If you purchased a home with a 15-year, fixed-rate mortgage for $250,000 after five years, with a conservative 3% appreciation rate, your home would be worth $289,818.52. Once paid off in 15 years, your home would be worth more than $139,000 over your original purchase price if it continued to appreciate at a constant 3% annually.
The chart below shows the continual appreciation over the course of a 15-year loan at 3%.
| Year | Rate of Increase | Home Value |
|---|---|---|
| Year 1 | 3% | $250,000 |
| Year 5 | 3% | $289,818.52 |
| Year 10 | 3% | $335,979.09 |
| Year 15 | 3% | $389,491.85 |
| Total Appreciation | $139,491.85 | |
Home Equity Loans
A home equity loan or home equity lines of credit (HELOC) that taps into the value of your home can qualify as good debt. For homeowners taking out the funds to complete value-enhancing home improvements or purchase another investment, the new debt could be good. But for homeowners who cannot afford a second mortgage payment, home equity loans can count as bad debt.
In general, beware that even good types of debt can have a negative impact on your finances if the interest is too high or the offer is not properly structured. For example, a loan or mortgage you can’t afford or one that includes a balloon payment would not be considered good for your finances.
Student Loans
Taking out student loans to attend trade school or college to attain the skills and experience to get a higher paying job could be considered a good debt. A study by The Georgetown University Center on Education And The Workforce found that over a lifetime, individuals with a Bachelor’s degree make 84% more than those with only a high school diploma. That said, interest rates vary depending on whether you use federal or private loans, so you’ll still want to consider the financial impact over time.
Business Loans
Taking out a business loan to finance your entrepreneurial dreams could be considered another form of good debt. If you’ve done the research and developed a solid business plan, it could be the infusion of cash needed to launch your business and financial future to new heights.
If you’re looking to start a business or you need help fleshing out ideas, contact your local Service Corps of Retired Executives (SCORE) by searching your local area for a volunteer. SCORE is the nation’s largest network of volunteer, expert business mentors across the country who provide free consultation services and advice to business owners and aspiring entrepreneurs.
Examples Of Bad Debt
Of course, there are plenty of bad debt options out there. Here’s a look at some of the most common types of bad debt:
- Credit cards: Credit card debt might be the most notorious example of bad debt. This type of debt often comes with sky-high interest rates on financed consumer goods.
- Payday loans: Payday loans are short-term loans with short repayment terms and high interest rates. The costs of a payday loan tend to wipe out the short-term benefit of resolving a cash crunch.
- Car loans: While you might need to finance a vehicle to get around, many households overspend on their car purchase. If possible, avoid buying more car than you can truly afford.
Benefits Of Managing Good Debt
While using good debt can be helpful in managing cash flow and making investments in your future, you still want to make sure you manage in responsibly. This includes making on-time payments and avoiding too much debt in your budget. In general, you want to keep your debt-to-income (DTI) ratio below 36%.
When you stick to smart debt management strategies, one of the many potential benefits is an improved credit score. A good credit score can unlock better loan terms and interest rates given by lenders on future loans.
How To Manage Good And Bad Debt
When you have both good and bad debt in your life, there are some smart strategies to employ. First things first, avoid taking on any debt that you cannot afford. While some good debt might be necessary in your life, too much of it will turn into a drain on your finances.
If you have a mix of good debt and bad debt, paying off your bad debt might be a priority for you. If you have available funds after making your minimum payments, funnel them towards your bad debt or highest interest debt first.
Regardless of whether you hold good or bad debt, do your best to consistently make on-time payments. Your payment history is a big factor in your credit score, which means on-time payments are a key part of a good score and strong credit history.
The Bottom Line
Debt can be good if the borrower manages the debt correctly and invests in assets that will appreciate in value. When investing in yourself, your business or your home, you are in control of your financial future. If you are ready to manage your debt and grow your wealth, start by signing up with Rocket MoneySM.
Sarah Sharkey
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