Good Debt vs. Bad Debt: What's the Difference?

The Federal Reserve Bank of New York reported U.S. household debt increased to $17.5 trillion in the fourth quarter of 2023. Credit card debt, mortgages and auto loans led to those debt figures. But not all debt is created equal. While some financial advisers suggest eliminating all debt, most will clarify the difference between good debt and bad debt.

A major factor in understanding good debt vs bad debt is interest rates. If you’re paying a lower interest rate to borrow money than you could earn on it through other investments, that’s good debt. If you’re paying high interest rates, like those on credit cards, that’s bad debt. But more fundamental to the good debt versus bad debt consideration is the debt’s purpose. Learning how to leverage debt for personal or business growth is an important financial skill. Read on to understand good and bad debts and how you can use good debt to create greater financial stability. 

What is Good Debt?

Good debt is a debt you take on to improve your earning potential or opportunities. While it’s debt in the short term, it can generate more income or a better quality of life. Borrowing to invest in a business, education or real estate is generally considered good debt. You’re investing in an asset or your own earning potential, which will help your finances long-term. But you should still approach these investments with a critical look at potential returns.

Examples of Good Debt

Debt can be a useful tool when used wisely. While it's important to avoid high-interest debt and overspending, there are instances where taking on debt can actually help improve your financial situation. Here are examples of good debt:

• Investing in education: Taking out student loans to invest in your education can be considered good debt. A college degree can lead to higher earning potential and better job opportunities in the future, making it a worthwhile investment in yourself.
• Purchasing a home: Taking out a mortgage to purchase a home can also be considered good debt. Not only does owning a home provide stability and a place to live, but it can also appreciate in value over time, potentially increasing your net worth.
• Starting a business: If you are starting a business or expanding an existing one, taking out a loan to finance growth can be a smart move. By investing in your business, you have the potential to increase your revenue and profitability in the future.
• Investing in real estate: Taking out a loan to invest in real estate can also be considered good debt. Real estate has the potential to appreciate in value over time, providing a return on your investment.

Good debt is typically characterized by low interest rates, long-term benefits, and the potential for future returns. Carefully check interest rates and fees to understand how much you’ll pay for the money you’re borrowing.

What is Bad Debt?

Bad debt has high interest rates or traps you into a cycle of taking on more debt. Prime suspects in the bad debt category are high-interest loans like payday loans and credit card debt. In both cases, you’ll pay so much interest that it can make it difficult to get out of debt.

According to financial advisors, a loan is generally considered bad debt if you are borrowing to purchase a depreciating asset. If your purchase won’t increase in value, generate income or increase your earning potential, you shouldn’t use debt to purchase it.

Examples of Bad Debt

Bad debt is something that everyone wants to avoid, but unfortunately, it can happen to even the most financially responsible individuals. This can have serious consequences for the individual's financial health and can lead to long-term problems. Here are some common examples of bad debt:

• Credit card debt: One of the most common forms of bad debt is credit card debt. This occurs when individuals charge purchases to their credit cards without the ability to pay off the balance in full each month. The high interest rates on credit cards can quickly result in a large amount of debt that is difficult to pay off.
• Payday loans: Payday loans are short-term, high-interest loans that are meant to be repaid with the borrower's next paycheck. However, many people end up rolling over their payday loans, accruing additional fees and interest, and creating a cycle of debt that can be difficult to break.
• Personal loans for discretionary expenses: Whether it's for a vacation, restaurant meals or clothes, taking on personal loans for discretionary expenses can lead to significant financial costs. Personal loans can also become bad debt if the borrower does not make the required payments on time. Missing payments or only making the minimum payment can result in a buildup of interest and late fees, making it even harder to pay off the loan.
• Medical bills: Unexpected medical expenses can quickly add up and become difficult to pay off, especially if the individual does not have health insurance. Medical bills that are left unpaid can negatively impact a person's credit score and lead to debt collection efforts.
• Long term auto loans: Taking out a long-term auto loan for a depreciating asset like a car means paying off the vehicle for an extended period even after its value has significantly decreased. Auto loans can become bad debt if the borrower is unable to make the monthly payments. In some cases, the lender may repossess the vehicle, leaving the borrower without transportation and still responsible for the remaining balance on the loan.

How to Differentiate Good Debt vs. Bad Debt

Here are the key factors to consider when determining whether the debt you are accumulating is ultimately beneficial or harmful to your financial situation.

• Interes rates: In general, avoid taking on debt with an interest rate above 7%. That’s the average return of the S&P 500 and assumes an average long-term return of investments in an index fund. There are exceptions to the interest rate rule, such as buying a house listed under market value or that you plan to refinance when interest rates drop.
• Loan repayment terms and fees: Does the lender tack on additional fees if you don’t pay the debt on time? Does the loan have collateral, such as a property you’ll lose if you don’t pay on time? Consider the consequences of late or missing a payment and how that will affect the total debt.
• Impact on your credit score: Taking on too much debt will affect your debt-to-income ratio and credit utilization ratio, which can harm your credit score.

Tips on Managing Debts Effectively

If you’ve already got bad debt, you’re not alone. Millions of Americans struggle with debt. However, with some strategic planning, you can pay off the bad debt, opening greater opportunities to leverage good debt for wealth-building.

Practical tips on how to tackle and manage debt include:

• Create a budget and get a handle on spending.
• Look for ways to save more each month to pay off debt.
• Consider cutting unnecessary expenses to free up funds for debt repayment.
• Find free or low-cost activities to replace high-cost ones, so you don’t feel like missing out.
• Pick a debt repayment method and stick with it. The two popular debt repayment strategies are the debt snowball and debt avalanche methods. The debt snowball method involves paying off debts with the lowest balance first, while the debt avalanche method focuses on paying off debts with the highest interest rates first. 
• Consider a debt consolidation loan or personal loan with a lower interest rate to help manage credit card debt and other high-interest debt.
• Consult with credit counselors or financial advisors who can help you create a debt management plan.

Final Tips on Bad Debt vs. Good Debt

Most consumers will take on good and bad debt at some point in their lives. The key is understanding the difference and creating a strategy to avoid bad debt. If you’re already carrying bad debt, paying it off as quickly as possible can free up hundreds in monthly savings. Ready to get started? Learn more about how to pay off credit card debt fast or learn about negotiating credit card debt and what happens to credit card debt when you die. 

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