How to Tell the Difference Between Good Debt and Bad Debt
- Some types of debt can improve your life, while others can be harmful.
- "Good debt" is an investment in your future -- a mortgage to buy a home, student debt for a degree to improve your earning potential, an auto loan to get transportation to work.
- "Bad debt" is borrowing for things you don't need, or borrowing for long periods of time to finance a short-term purchase -- like a 20-year home equity loan to cover a vacation.
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Being in debt can feel like an endless struggle—especially if you’re dealing with multiple kinds of debt, like mortgages, student loans, auto loans, and credit card debt. Making payments on all these different types of debt can be tough, and getting ahead might seem impossible. To make things worse, you might not even know which debts to start paying off first, or the meaning of “good debt” vs. “bad debt.”
It’s an unfortunate fact that debt is a way of life in the United States, which had nearly $14 trillion in outstanding household debt at the end of the third quarter of 2019. Almost every major purchase, financial milestone, or life event has a debt amount tacked onto it. And if you aren’t part of “the 1%,” you might spend years working to overcome your debt.
If you’re one of the millions of Americans in debt, you might be surprised to learn that not all debt is bad debt. In fact, some debts can be useful if you want to make more money, buy a home, or improve your finances. Being able to understand “good debt” vs. “bad debt”, and the key differences between the two, could help you figure out which of your debts you need to worry about first, and which can wait for later.
Not all debt is bad debt. In fact, some debts are useful if you want to make more money, buy a home, or improve your finances.
Any debt that helps you build wealth or create a better financial future can be considered good debt. Good debt helps you find a higher-paying job, own a home rather than rent, and increase your income potential. A few kinds of good debt include:
Even though it may take 15 to 30 years to pay off, a mortgage could be a good type of debt. Going from being a renter to a homeowner may be smart because the money you put towards your mortgage could go back into your pocket if you decide to sell your home. And if you pay off your mortgage and decide not to sell, you can put that money into savings or invest it for an even higher return. As long as you have equity, there are many ways to use your home mortgage to better your financial situation.
2. Student loans
Spending money on your education could help you make more money in the future. Even if it means going into debt, student loans ideally pay for themselves in the long run because of the new career opportunities they could enable. In fact, college degree holders earned 56% more than high school grads in 2015. However, when considering good debt vs. bad debt, student loans can be problematic if they don’t result in that higher-paying job.
3. Small business loans
Putting money behind your small business idea could be a solid decision because the goal of any small business is to make more money. If you’re a hard worker and have a solid business plan, your small business loan could give you the capital you need to set yourself up for growth and ultimate financial success. Keep in mind, however, that starting any kind of business is inherently risky, so it’s important to properly manage that debt.
Good debt isn’t good for everyone in every situation
Other types of good debt also may include certain auto loans (especially if a better car allows you to pick up a side gig or drive to a higher-paying job), rental property, and investments that should increase in value over time. But the good debt vs. bad debt distinction isn’t always so clear, especially if you don’t have the cash to pay it off. Even if you take out a good debt, you need to make sure that you’re getting the most value possible.
When it comes to taking out a mortgage, small business loan, or student loan, it’s smart to be frugal. Remember: a good debt is only good if it fits your budget and ultimately makes sense. Always think about what you can afford to spend each month on debt before you take out a new loan—preferably by making a monthly budget—otherwise you may end up having to take out a bad debt to cover the cost of a good one.
Generally, if you take out a debt on anything that will decrease in value over time, that debt can be considered a bad debt. There are a few different ways to get into bad debt:
1. Credit Card Debt
One of the most common forms of bad debt is credit card debt. In December of 2019, American households racked up $466.2 billion of debt had an average credit card debt amount of $7,104. Though some consumers accumulate credit card debt buying things they don’t really need, America’s dependence on debt is also linked to stagnant household income and rising costs. Unfortunately, relying on credit cards to pay for essentials can be a slippery slope.
With average APRs hovering around 14 percent for many credit cards, credit card debt could end up costing you thousands in interest alone by the time you pay it off—making it one of the worst kinds of bad debt.
2. Personal Loans
Personal loans can be used for almost anything—from paying for a vacation or wedding to consolidating your credit card debt. While personal loans usually have lower rates than most credit cards, they can be used to purchase items that will decrease in value over time (unlike a mortgage on a house, which should increase in value). That’s why they’re considered a bad debt.
3. Payday Loans
Borrowing in the short term could really hurt you over time. Payday loans usually charge you an additional dollar amount for every $100 dollars you need to borrow, ranging from $10-$30. But if you can’t pay within the given amount of time, you could get hit with additional fees. Since payday loans are one of the most expensive types of loans and there are harsh consequences if you can’t pay them back, they are considered bad debt.
Wages have remained stagnant over many years, relative to the cost of living. With no savings and nowhere to turn, many Americans get into bad debt because it’s the only way to get by. If you find yourself in a bad debt situation, there are a few ways to help deal with your money problems.
How to Deal with Bad Debt
The first step in dealing with bad debt is figuring out which of your debts actually could be bad. After you pinpoint the credit card, personal loan, and payday loans that need to be eliminated, try and come up with a plan to pay if off as fast as you can.
One option is debt consolidation, but if you have a lot of bad debt, a debt consolidation loan may not be your best option. Debt consolidation loans could end up being another form of bad debt if you maintain the spending habits that got you into debt in the first place. Since you have less time to pay off a debt consolidation loan, your payments could be higher than they were before you added the loan.
Another option if you’re struggling with $15,000 or more in bad debt, like credit card debt, is debt settlement. You can do this on your own, but professional debt negotiators have more experience and leverage and often may get larger debt settlements than you could as an individual working alone.
Now that you know your options, could you use some help with your finances?
Understanding good debt vs. bad debt, how interest rates work, and other aspects of consumer debt will help you improve your financial well being. But if you’re struggling with debt, it might be time to take action. Freedom Debt Relief is here to help you understand your debt-relief options, including our debt settlement program. Our Certified Debt Consultants can help you get a handle on your situation and minimize your bad debt. Find out if you qualify right now.