Good Debt vs. Bad Debt: What’s the Difference?
Debt isn't always bad. Nor is it always good. It all comes down to how you use it.
In personal finance, there’s a four-letter word that can evoke a lot of emotion: debt. People get into debt for many reasons. Some take out student loans to bridge the gap in funding for school, while others take out a mortgage to buy the home of their dreams. Yet others turn to credit cards or personal loans to cover expenses.
Debt isn’t fun for anyone, as it requires borrowing money from a lender and paying it back with interest. That said, not all debt is created equal. In fact, some people say that there’s good debt and bad debt. But what does good debt vs. bad debt mean, anyway?
Further Reading: “Debt Is Like an Instrument, It’s All in How You Play It”
What is Good Debt?
You might think that the term good debt is an oxymoron. And in some ways it is. Debt isn’t really a good thing for anyone, but there are some types that are better than others. Good debt is typically leveraged to create wealth or opportunities. Here are some examples of what might fall under that category:
- Student loans
- Small-business loans
Whether you want to take out a mortgage to buy the home of your dreams or to invest in a property, taking on debt for real estate is typically considered a good move. Why? Housing is a reliable investment, as people will always need a place to live. Taking out a mortgage — a form of debt — can help you to obtain an item that has equity. You can rent the home out or sell it at a profit later. Of course, the housing market can change at any time (we know what happened in 2008), so it’s important to understand real-estate trends and economic factors.
2. Student Loans
Pursuing higher education is typically considered an investment in your future. Earning a college degree can help you earn more money than you would otherwise. That’s why student loans are considered to be good debt. In short, you’re taking on debt to pursue an education, specialize in a certain field, and leverage your knowledge to further your career. Though student loans are considered good debt, many borrowers still feel the pinch, since they may struggle to find the job of their dreams after college. While higher education can be a good investment, it’s not a surefire path to a career anymore.
Further Reading: Learn about student loan refinancing.
3. Small-Business Loans
Do you have a brilliant business idea, but lack the funds to pursue it? A small-business loan might be considered good debt for you, since you can leverage it to get your business off the ground.
If your business turns profitable, you can pay back your loan and start earning a return on your investment.
A business is supposed to generate revenue, and if you have a strong plan — along with some heart and hustle — a small-business loan could help you get a return on your investment.
What is Bad Debt?
Going into debt for something like a credit card or car may result in a mountain of interest for something that ends up having little value.
1. Credit Card Debt
There’s no doubt that credit card debt is considered bad. Why? Because it has some of the highest interest rates of any kind of debt, with an average of 15 percent. Making minimum payments on your credit card debt could mean years of repayment and a whole lot in interest.
Further Reading: “How I Won My War Against Credit Card Debt”
2. Auto Loans
This one might be a bit confusing. Everyone needs a car, and the interest rates aren’t that bad, right? Not always. While the terms and interest may not be as high as other types of loans, there’s one thing that clearly puts this in the “bad” category: Cars rapidly depreciate as soon as you drive them off the lot. They will never be worth what you paid for them. In other words, their value is always sinking. This is why taking out an auto loan isn’t necessarily the best deal in town.
Good Debt vs. Bad Debt: The Bottom Line
If you’re thinking about taking on debt, it’s important to understand how it will serve you and your goals. Will the debt be useful? Will you be able to get a return on your investment? Or will you end up losing even more money? Sometimes you don’t have a choice, but it’s still important to consider whether you can leverage the debt in a positive way or whether it’s going to end up being a big weight constantly pressing down on you.
Further Reading: “Debunking the Good Debt vs. Bad Debt Myth”