What Is Good Debt Vs. Bad Debt?

The word “debt” often gets a bad reputation since having excessive debt can be one indicator of poor financial health. While some kinds of debt are definitely bad, did you know that other kinds can actually be good?

Read on to learn what good debt is, as we explore the difference between good debt vs. bad debt and how both types can affect your finances.

Is Debt Bad?

Whether debt is good or bad depends on how you use it. Debt that improves your finances and builds wealth is typically considered good debt. When you invest money in items that don’t increase in value or have long-term benefits, the debt is categorized as bad. It’s important to take out debt responsibly and for the right reasons.

Any type of debt that results from your own personal consumption is called consumer debt. Many types of debt fall under this category, including: 

• Secured debt: This is any type of debt that uses collateral, like a home or car, as a form of security for the lender in the event that you’re unable to repay. While you’ll usually pay less in interest, you run the risk of losing the asset you put up as collateral.
• Unsecured debt: Unlike secured debt, unsecured debt is the result of taking out loans that don’t require collateral. Since this is riskier for the lender, you can expect higher interest rates and possibly stricter qualifications. Examples of unsecured debt include student loans, credit cards, personal loans, and medical bills.
• Revolving debt: Like a revolving door that allows you to continuously go in and out, revolving debt can pile up fast as you’re able to borrow on a recurring basis up to a limit – so long as you repay. If you don’t fully pay your debt each month, however, you’ll also be charged interest. Credit cards and lines of credit are two examples of revolving debt.
• Non-revolving debt: Non-revolving debt is a one-time loan that you pay back with interest over a specified period of time. This type of debt is common with very expensive purchases that consumers may not be able to pay for all at once, such as a house, car or college tuition.
• Mortgage: If you’re a current or aspiring homeowner, you’re likely familiar with mortgage debt. Using the house itself as collateral, mortgages allow homeowners to purchase a property in monthly installments over 15 or 30 years. With the right financial planning, this type of debt is often classified as “good,” which we’ll discuss more in-depth below.

What Is Good Debt?

We’ve already established that not all debt is bad. So, what exactly is good debt?

Essentially, good debt consists of financial obligations that you plan for and can afford – taking it on as a way to reach major financial or personal goals.

Before deciding to take on debt, you can determine whether it may be good or bad by calculating your return on investment, or ROI. ROI compares the amount of debt you’re taking on to how much you can expect to earn (or lose).

Reaching certain life goals – such as going to college or buying a home – will more than likely come with debt. However, depending on your ROI, such debt can actually be a good investment – increasing your earning potential and quality of life.

To calculate your ROI, divide your net profit by the cost of your investment and then multiply that figure by 100.

Examples Of Good Debt

Let’s consider a few financial situations that may require you to take on good debt.

Mortgages

Homeownership is a major life goal for many adults. Taking out a mortgage puts this goal closer within reach for many. A mortgage allows a homeowner to pay off their home in monthly payments, usually over a 15 – 30-year period.

There’s no guarantee that taking on debt from homeownership will pay off financially. Still, mortgages are typically considered good debt for several reasons. One huge reason is that a home’s assessed value can appreciate over time, which can boost your ROI. Other benefits of homeownership include: saving money on rent, greater financial stability, tax benefits, and a more comfortable lifestyle.

Say, for example, you bought a home with a 15-year, fixed-rate mortgage for $250,000. After just 5 years, with a 3% appreciation rate, your home would be worth $289,818.52. At the end of your 15-year loan term, (assuming a constant 3% annual appreciation) your home would be worth about $139,000 more than what you originally paid.

The chart below shows how your home’s value would appreciate over the course of a 15-year loan at 3%.

Home Equity Line Of Credit

Home equity lines of credit (HELOCs) allow homeowners to take equity out of their homes in the form of a loan, either as a lump sum (home equity loan) or an open line of credit (HELOC). Simply put, equity is the amount of home you own – that is, the difference between your home’s value and what you still owe.

HELOCs can be good debt if you’re using the loan to make home improvements that will increase the value of your home. You might also decide to use your equity loan for another investment with a high ROI.

On the other hand, taking out a HELOC might be considered bad debt if you’re unable to afford a second mortgage payment.

Keep in mind that even good types of debt can negatively affect your financial health if loan terms are unfavorable or you cannot properly manage the debt.

Student Loans

The rising cost of attending college or a trade school can put students into debt that often takes years to repay. However, student loans are generally considered good debt because they help people gain the experience and skills needed to earn higher-paying jobs. In fact, one scholarly study found that individuals with a bachelor’s degree make 84% more in their lifetime than those with only a high school diploma.

Remember, though, that student loan interest rates vary based on whether you use federal or private loans. Repaying student loans on time can help to keep interest rates low and maximize the value of your education.

Your specific degree or certification, along with the current job market and other unique circumstances, can also impact your ROI. So, before taking out student loans, carefully consider the financial impact. 

Business Loans

Entrepreneurship can offer financial freedom and a more flexible lifestyle. However, starting or growing your business may require taking out a loan. A business loan can be good debt if you’ve done adequate research and developed a sound business plan. On the contrary, business loans could result in bad debt without a clear entrepreneurial vision and proper financial planning.

What Is Bad Debt?

Unlike good debt, bad debt is the result of borrowing money to buy goods and services that depreciate in value. Bad debt is usually a financial obligation that the borrower can’t afford and will result in the loss of more money. And while good debt can become bad debt if improperly managed, bad debt rarely ever turns into good debt. 

Examples Of Bad Debt

Knowing what’s considered bad debt can alert you to unnecessary debt in your life, empowering you to make financial changes if needed. Here are some common types of bad debt.

Credit Cards

Credit cards are infamous for entrapping consumers into bad debt because of how easy they make it to spend more than you can afford. Credit card debt often brings steep interest rates on financed consumer goods that offer no future return.

When used responsibly, credit cards can be an excellent way to build your credit history and strengthen your buying power. If used unwisely, though, credit card debt can lead to financial disaster.

Payday Loans

When borrowers are strapped for cash, payday loans provide immediate access to credit. They’re called payday loans because lenders usually require the borrower to show a pay stub as proof of income. Then, borrowers must repay the loan within a short period of time, generally 30 days or less.

While payday loans can be tempting if you’re in a bind, they’re categorized as bad debt because of the high interest rates and high fees for missed repayments. Before taking out a payday loan, it may be helpful to consider alternatives like personal loans or cash advances.

Auto Loans

A car loan, also called an auto loan, makes it possible to take out a lump sum of money and then repay the amount plus interest in monthly installments, using your car as collateral.

Auto loans are often considered bad debt because the car’s value depreciates as soon as you buy it. And with high interest rates, you could end up paying more than what the car is even worth. This is why, if possible, it’s often best to buy a car you can afford rather than overspending.

Boat Loans

Similar to a car loan, a boat loan can finance the purchase of a boat while you pay back the money over time. Unlike a car, however, a boat isn’t quite an essential expense. This often means higher interest rates. Not to mention, a boat’s value drops significantly once purchased.

Ways To Manage Good Debt

Since good debt is still debt, it’s absolutely vital to manage it strategically and responsibly. Consider some practical ways to manage good debt.

• Keep your debt-to-income ratio (DTI) below 40%: Your debt-to-income ratio (DTI) reflects how much of your income goes toward paying off debt. Keeping your DTI below 40% can ensure that you still have money for living expenses and savings, while working to pay off your good debt.
• Improve your credit score: The higher your credit score, the better your loan terms usually are should you need to take one out. Lower interest rates mean you can pay off debt quicker and avoid incurring more debt.
• Maintain a healthy credit mix: A healthy credit mix means having different types of credit accounts such as mortgages, loans and credit cards. Lenders see this as a sign of being able to responsibly manage and pay off debt. 
• Avoid debt you can’t afford: Even good debt can hurt your overall financial health if you’re unable to afford it. While some good debt may be necessary, you’ll likely need to say no to other debt – even if it’s considered good.
• Make and maintain a budget: To minimize the negative financial effects of good debt, it’s important to create and stick to a budget. A budget can help you keep track of your spending, while also alerting you to any unnecessary expenses you might need to eliminate. The money you save using a budget can go toward paying off your good debt.

The Bottom Line: Debt Doesn’t Have To Be A Bad Thing

Having debt isn’t always negative; in fact, debt can actually be good if you can manage it properly and make investments that offer high returns.

If you’re ready to take control of your financial future, you need a tool that will help you cut out bad debt and put you in a better position to take on good debt. Download the Rocket Money^SM app today to start tracking and managing debt.