The Difference Between Good Debt and Bad Debt

Are you in debt? If so, you’re definitely not alone. According to the Federal Reserve, Americans owe more than $1 trillion in credit card debt alone. But what does that mean for your financial future? Is all debt created equal, or are some types of debt better than others?

Understanding the differences between good debt and bad debt is critical for making smart borrowing decisions and achieving long-term financial health. Properly managing debt can provide financial stability, while mismanaging debt can lead to serious financial problems.

For most people, debt is always bad, if often unavoidable. Did you know there is actually such a thing as good debt? Absolutely!

Let’s take a look at good debt and bad debt and why they are considered good and bad debt.

What is Debt?

So this is a bit obvious, but a good definition will help later. Debt is something that is owed to someone else. For a comprehensive understanding, familiarize yourself with these important financial terms. It can be physical, mental, or emotional. For the purposes of this blog, debt is money that is owed to someone else.

When you acquire debt, there is usually some sort of repayment schedule, fees and penalties for failing to repay debt, and interest - a percentage fee charged by the lender in order to let you use their money.

When you repay your debt in a timely manner, it is reported to a credit bureau and becomes part of your credit history. The credit score developed from your credit history suggests to other lenders whether or not you are a good risk for future loans.

For more about credit history and credit scores, follow this link.

Bad Debt

Bad debt is incurred when you purchase an item that loses value very quickly. For instance, spending a lot of money on clothing or shoes is bad debt. The clothing loses value, or depreciates, immediately. You can not realistically resell it for what you purchased it for.

Bad debt also often comes with very high-interest rates, like payday loans and credit cards over 20%. These high rates make the debt much more difficult to repay. Bad debt also includes appliances, vehicles, entertainment, credit card debt, and payday loans. You need clothing but going into debt to purchase clothing is definitely bad debt. Payday loans are always bad debt.

They come with usuriously high interest rates, in some cases up to 500% which means that if you borrow $100, you repay $500. Your main financial goal should be to avoid as much bad debt as possible. Taking on debt that doesn't align with your financial goals can also be considered bad debt. For example, borrowing money to take a luxury vacation when you should be saving for a down payment on a house.

Good Debt

Good debt is debt that involves the purchase of something that increases in value. Good debt includes mortgages, home equity loans, student loans, and small business loans. But wait... I need a car to get to work. Surely that is good debt? This is where the concept of gray debt comes into play. It is very easy for good debt to become bad debt and vice versa.

Mortgages

Taking on mortgage debt to finance a home purchase can be considered good debt because you are borrowing to buy an appreciating asset. As long as you can afford the monthly payments, a mortgage allows you to build equity in your home over time. Be sure to shop around for the best interest rate and avoid borrowing more than you can reasonably afford.

Student Loans

Student loans allow you to invest in your education and increase your earning potential. However, it's important to be strategic - make sure you are taking on student debt for a program that leads to a lucrative career. Degrees like engineering, accounting, and healthcare often have high salaries that make student loan debt manageable. Avoid high debt loads for degrees with poor job placement or lower earning potential.

Small Business Loans

Borrowing to start or expand a business can be good debt if used to purchase appreciating assets or finance growth. Be sure to have a solid business plan that projects revenue and expenses. It's smart to only take on debt that the business can realistically repay in a few years based on expected cash flow.

0% Introductory APR Credit Cards

Opening a credit card with a 0% intro APR offer can provide an interest-free loan if paid off before the intro period ends. This allows you to finance a large purchase over 12-18 months without paying interest. However, these cards must be used strategically - have a repayment plan and avoid late fees to keep it as good debt.

Gray Debt

Gray debt includes mortgages, home equity loans, credit cards, student loans, and vehicles. Since this is pretty much the same as good debt, what makes it gray? For instance, most people will never be able to save up enough to buy a house of any description.

To have a home, they must have a mortgage. The goal of buying a house is, besides somewhere to live, is to build equity and have your home increase in value over time. However, if you buy a house that is more expensive than you can afford or you have the misfortune to buy a house in a volatile market, this is gray debt.

You are now in danger of your mortgage becoming bad debt. If you lose your home, it is now a bad debt and will haunt you for up to ten years.

Cars immediately depreciate after you buy them. In other words, you can not resell them for what you just paid for them. For most people, a car is necessary to have a job - good debt. Buying a more expensive car than you can afford is bad debt.

Sure the salesperson said they can get you into that $50,000 car for $300 a month and a $1000 down. Pretty soon you will owe more on your car than it is worth. However, buying a less expensive car can get you to work and back in good debt.

Auto leases can also fall into the gray debt category. Leasing a reasonable car with affordable payments can be good debt, but leasing an expensive car you can barely afford turns into bad debt.

Credit Card Debt

The most common type of debt for most Americans is credit card debt. At least half the blogs on Pacific Debt, Inc. deal with credit card debt and how to get out of debt. Credit cards are convenient but they can drag you very quickly into bad debt. Use credit cards responsibly and pay them off in full every month to avoid bad debt.

FAQs

Our Take

The key differences between good and bad debt come down to interest rates, alignment with financial goals, and repayment terms. Good debt generally has reasonable interest rates, helps build assets, and has manageable repayment terms. Bad debt often has high-interest rates, doesn't build value, and has unrealistic repayment terms.

Debt is generally difficult for most people to avoid. Try to avoid bad debt and focus on good debt that you pay off as quickly as possible. By making mindful spending choices, you'll find it easier to avoid bad debt in the first place. Additionally, being informed about multiple ways to manage debt can provide you with strategies to maintain financial stability.

Conclusion

Understanding the differences between good debt and bad debt is key to making smart borrowing choices that set you up for long-term financial success. The bottom line is that good debt moves you forward by building assets, while bad debt holds you back. As you take on new debts, be sure to evaluate whether it aligns with your financial goals and if the repayment terms are affordable. 

With mindful borrowing, good debt can be a strategic tool to invest in your future. However, bad debt has the potential to spiral out of control, leading to financial distress. In such cases, exploring the best debt relief options can be an essential step toward regaining financial stability. It's best to avoid bad debt when possible.

If you find your debt has become too much for you to take  on, don't hesitate to contact us for a free consultation on how you can reduce it.