Debt is often discussed in negative terms, but debt isn’t just good or bad. It falls on a spectrum, and how you manage it plays a big role in how it impacts your finances.
Bad debt is usually high-interest credit cards that quickly accrue interest if you only make minimum payments. Good debt, such as a mortgage or student loan, can help you build long-term value and typically comes with much lower interest rates. Once you’ve paid off good debt, you often have an appreciating asset — your house or your college degree, for example.
What is debt?
Debt is money that is borrowed from an organization like a bank, credit union or online lender. Most debt is paid back with interest, which can be either fixed or variable. With either option, it is calculated based on the principal and is calculated at the end of a compounding period. A compounding period can be quarterly, monthly or even daily, which is the case with credit card interest.
Good debt
Good debt, which typically carries lower interest rates, is debt used to finance an expense or asset that has the potential to generate future income or financial growth.
For example, mortgages and home equity loans can be used to purchase or renovate a house, which might appreciate in value. Student loans are also generally considered good debt because college degrees tend to lead to higher-paying jobs.
When looking at good debt, the interest should be low — generally under 10% — and the asset or expense you’re purchasing should be part of your long-term financial future.
Bad debt
Bad debt, which typically carries higher interest rates, is debt used to pay for depreciating assets or one-time expenses that don’t provide long-term financial value.
For example, financing a vacation with a credit card is generally considered a poor financial decision. Because current credit card interest rates are over 20%, you’ll end up paying hundreds of dollars in interest unless you zero out your balance before the end of your billing cycle. If you opt for minimum payments, debt can quickly grow out of control.
Payday loans — and some bad credit personal loans — are bad debt depending on what you use the money for. It’s possible that an emergency loan may be necessary, but you’ll wind up paying a significant amount of interest over the life of the loan.
Neutral debt
Depending on how debt is used and how quickly you’re able to repay it, some bad debt can be neutral under the right circumstances. Credit cards won’t accrue any interest when the balance is paid in full each month. Similarly, auto loans finance a depreciating asset — but because of their low interest rates, they can still be a good way to get a car that you might otherwise not be able to afford.
Good debt can also be neutral. For example, a home improvement loan can be used to finance a renovation to your home, but the return on your investment will likely be lower than the actual cost of the loan. You’ll be in the red, but the expense will be worth the result.
How to spot the difference between good debt vs. bad debt
Although we’ve defined what’s typically considered good debt and bad debt, at the end of the day, that distinction depends on the person.
Short-term, high-interest debt might not be considered bad debt to someone who had no choice but to put that expense on a credit card. Similarly, student loan debt, though considered a good debt because of the long-term financial return, can lead to overwhelming repayments for many people.
However you define good debt or bad debt, always consider your larger financial picture before taking out a loan of any type, especially a payday loan or cash advance on your credit card. If you can’t afford to make payments or don’t have a plan to pay off your debt, even good debt can cause significant problems.
Bottom line
Deciding which debt is good or bad for you depends on your goals and repayment strategy. Whichever type of debt you decide to — or have to — take on, consider your financial situation first. All debt incurs interest at some point, so it’s best to pay off any debt as soon as your budget allows.
If you’ve taken on more debt than you can handle, look into options that fall under the debt relief umbrella. Credit counseling, debt consolidation and debt settlement are all ways to manage bad debt. It may not be easy, but it can help you learn how to better manage your debt and anticipate potential drawbacks.
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