How to Differentiate Good Debt Versus Bad Debt
Financial advice often differentiates between good and bad debt. But how can you determine which type you're taking on?
Understanding why some types of debt are considered more beneficial than others can help you make the best decisions for your finances. Here's what you need to know about good debt versus bad debt.
What defines good debt
In general, financial experts consider good debt to be money you can borrow inexpensively to purchase something that will add value to your life and your finances over time. Generally, things like a mortgage or student loans fall into this category.
Bad debt, on the other, might be best described as borrowing money to purchase something that doesn't generate a lot of value—especially if you don't have a clear strategy to pay it back. Credit card debt incurred by shopping for luxury items is an example of this kind of debt.
Debt should also be affordable to be considered good. That means that you can afford the monthly payments and that you're borrowing at low or inexpensive interest rates. In the best cases, you'll get more value out of your good debt than you pay in principal plus interest.
Key questions to ask
Of course, debt is more than just a simple matter of good versus bad. What makes sense for you depends on your specific circumstances, and good debt for one person might be bad debt for another depending on their strategy and their ability to pay it off.
Here are things you might want to consider when deciding if a debt qualifies as good or bad.
What are you purchasing, and why?
Even if it's something that won't increase in resale value—like homes typically do, for example—the purchase could still add value to your life if it's something you need or that will help you grow your money. For instance, taking on a low-cost auto loan to afford a vehicle that's essential to your work could be a good debt choice.
How much will you pay for your loan?
Knowing exactly how much your debt will cost over time is part of making good decisions. Between the amount you borrow, the interest rate you pay and the amount of time it will take you to pay off the debt, the total cost could be too expensive to make the purchase worthwhile.
On the other hand, low-cost debt that you can pay off quickly might make sense for your particular situation. Calculating your total costs can help you decide where the debt falls on the good versus bad scale.
Do you have a plan for paying off the debt?
Avoid taking on debt without having a payoff plan. Even debt for purchases that are necessary or have strategic purpose can be a poor choice if you have no specific plan to get the debt paid off.
Examples of good debt
So what are some examples of good debt? Several types of loans and financial products may fit the description.
- Student loans: A higher education typically helps increase your income potential. Student loans also often tend to have low interest rates and favorable terms.
- Mortgages: Buying a house is one of the traditional ways to increase your net worth, and a mortgage makes this kind of purchase possible.
- Small business loans: These can help entrepreneurs to start or build their businesses.
- Home equity loan: These loans often have very inexpensive interest rates, and provided you're using the loan to increase the value of your home, they can meet the criteria for good debt.
- Secured credit card: These cards require a refundable security deposit that represents your credit limit. They can allow new borrowers to build their credit history without getting overwhelmed. Rates for these cards also tend to be low.
- Secured CD loan: This kind of personal loan requires a CD as collateral and generally offers low rates. Such a loan can also help build credit.
Be a smart borrower
Good debt means taking a low-cost loan that will help you grow your finances and creating a solid plan for repayment. Smart borrowers consider all these factors to make sure they're sticking to good debt.
