Understanding the Difference Between Good Debt and Bad Debt

June 11, 2024

Debt is a common aspect of modern life. While debt has a negative connotation, debt is something most people carry and not necessarily a bad thing. For most people, debt is required when making major purchases in life. Whether you’re financing a car, purchasing a home, pursuing higher education, or simply managing daily expenses, understanding the distinction between good debt and bad debt is crucial for financial health. This article explores the differences, provides examples of each, and explains why some debts can be beneficial while others can be detrimental.

Good Debt: A Pathway to Financial Growth

Good debt can be considered an investment in your future and something that creates value and generates long-term income or appreciates over time. The primary characteristic of good debt is that it helps you acquire assets or improve your financial position. When managed properly, it can lead to increased wealth and financial security.

Examples of Good Debt

1. Mortgage Loans:

Purchasing a home is a wise long-term investment strategy. Real estate generally appreciates (gains value) over time. Several years after purchase or when you pay it off, the value of your home could be worth significantly more than the amount you purchased it for. This added value is referred to as equity, which is an asset. Additionally, mortgage interest is often tax-deductible, adding another financial benefit. These factors lead to a home purchase mortgage generally being “good debt” and a wise investment of your money.

However, there are factors that can come into play that you should be mindful of that may swing things the opposite direction. The housing market is one of those and the actual price you pay to obtain the house if there is high demand. The economy, the location of the house, it’s condition, etc are all factors that come into play when determining if a mortgage loan on a house is a good or bad investment. But based on a long history of homes generally increasing in value, a mortgage will tend to be “Good Debt.”

2. Home Equity

Similar to how a mortgage is good debt, leveraging the equity you’ve established in this investment is also good debt. Using the value and equity of this asset can provide you with funds through a Home Equity Loan or Line-of-Credit. Based on how you use the funds pulled from the equity in your home these loans can be considered “good debt.”

As your home increases in value and you regularly make your mortgage payments you are gradually building equity based on the difference between your home’s value and the balance of your mortgage.

You can then borrow on this equity to access needed funds. This remains good debt as long as those funds are used responsibly for something that adds value (home improvements, college financing, etc). Borrowing against the equity for something that doesn’t add more value to your financial health, like a vacation , could be considered “bad debt.”

3. Student Loans:

Student loans can be a touchy subject, especially when weighing in on good or bad debt. Many concur that earning a college degree is a valuable asset. Depending on the degree you earn and the field you choose, the intention is to be on a path towards gaining a career that earns a higher income and sustainable financial future. Subsequently you’ll be on a path then to pay off that student debt sooner. Over time, the increased income can outweigh the initial loan amount and interest.

4. Auto Loans:

A loan that most will have throughout their life is an auto loan. Depending on where you live and work, a vehicle could be necessary for your everyday activities in life. Although vehicles do depreciate (lose value) each year, they do hold a higher value longer and are considered good debt because of their importance.

However, it is important that you should strive to minimize the auto loan debt by finding a reliable and affordable vehicle and not over-extending your budget for a flashy ride. It can also be wise to buy a used vehicle to control your loan amount rather than purchasing a car that may be out of your price range.

Lastly, pay attention to all the costs involved in the purchase, your loan interest rate, and the term. A typical term for an auto loan is 60-months. While going longer can reduce your monthly payment, you will end up paying more because of the added interest accrual for the extended period of time.

While the above are all examples of good debt, they all come with the caveat of ensuring you can afford the loan payments along with other expenses you have in your life. Good debt can quickly turn into bad debt if you take on more than you can afford or don’t manage the debt properly.

Bad Debt: A Roadblock to Financial Stability

Bad debt is incurred to purchase items that quickly lose their value and do not generate income. This type of debt often carries a higher interest rate and does not contribute to improving your financial situation. High-interest rates and the lack of return on investment mean you pay more for items that lose value, often leading to financial strain.

Examples of Bad Debt

1. Credit Card Debt:

Credit cards can be good, but credit card debit is bad. A good tool to have in your wallet, credit cards do provide flexibility and purchasing power when needed. However, they carry high interest rates, sometimes exceeding 20%, and should be used cautiously as balances can quickly build up and spiral out of control beyond what you can afford. If not paid off monthly, the interest can quickly compound, leading to significant debt for non-essential items like dining out, vacations, or electronics.

When used wisely, they can provide worthwhile rewards and are a great tool to build your credit. That requires responsibility and proper budgeting to ensure you regularly make payments and pay off your monthly balances.

2. High-rate Personal Loans for Non-Essential Expenses:

Personal Loans can be essential when needing to make larger purchases. Sometimes referred to as unsecured loans, personal loans are not attached to any specific collateral or property such as a home or vehicle. Since there is no collateral a lender can collect if you default on the loan, there is higher risk involved and therefore interest rates tend to be higher on these loans.

While personal loans have valid purposes and can be necessary, they can be classified as “bad debt” depending on what the funds are used for, how much, and how long the loan term is. Personal loans should be used responsibly. When used for an expensive vacation, a new “toy” or high-end consumer good, or something else that doesn’t build or add value, they become “bad debt.”

3. Pay Day Loans

If there is any debt to avoid at all costs, it is the worst of the bad, pay day loans. This quick access to cash comes with many fees and ridiculously high rates. They should be avoided at all costs. Don’t give away your hard-earned money so easily. There are much better ways to get the cash you need in a timely manner.

As we opened with, debt to finance major expenses is a common aspect of our lives. Everyone’s needs and financial positions are different. All debt should be used with caution and responsibly managed. How you use and effectively manage your debts is what determines if it truly is good or bad debt.

Understanding the difference between good debt and bad debt is vital for making informed financial decisions. Good debt can help build wealth and improve your financial position, while bad debt can lead to financial instability and stress. By focusing on borrowing for assets that appreciate or generate income, and avoiding debt for depreciating items or short-term pleasures, you can maintain a healthier financial outlook and work towards long-term financial goals.