Good Debt Vs. Bad Debt: Knowing The Difference
Matt Cardwell5-Minute Read
UPDATED: July 27, 2023
You might think that all debt is bad, but that’s not necessarily true. Debt that can directly benefit the borrower can be seen as “good debt.” Some debt can negatively affect the borrower’s life and finances, though, and is seen as “bad debt.”
How will you know if the debt you’re taking on is good or bad? This article will explain how you can know what kind of debt you’re taking on ahead of time, and guide you through some examples of both good and bad debt.
What Is Good Debt?
Good debt can impact your life in a positive way. Low-interest debt that you can repay responsibly, and possibly profit from down the road, can signal that you’re taking on good debt. Good debt can also have a positive impact on your net worth – your total accumulated wealth and assets – and increase your income and finances.
Let’s take a look at some examples of good debt, and see how these loans can set you up for a successful financial future.
Buying a home can be one of the biggest investments you make in life, and the rewards of doing so put it in the category of good debt.
The most obvious benefit of buying a home is that you get a place to live – one that you own, no less – and equity that’ll increase over time. If and when you move, you could potentially sell the home for more than you bought it for. Those benefits alone can make taking out a mortgage a good form of debt. Additionally, in certain cases, you can even deduct your mortgage’s interest from your taxes.
If you take out a home improvement loan, like a home equity loan or a home equity line of credit (HELOC), you can also potentially deduct that interest as well, as long as the loan is only used for renovations.
Taking out student loans to attend college, graduate school or earn a technical degree can be a great investment in your future. Being able to afford higher education could set you up for higher-paying jobs and career opportunities down the line, in turn increasing your income and net worth. Additionally, some student loans can come with low interest rates, especially federal loans.
Small Business Loans
Financing a small business can be an investment with high returns for you and your household. A profitable business can generate a steady cash flow that increases your income and net worth. If the day comes that you want to sell the business, you can potentially make back the money you put into it and more. Not only that, but business-related expenses can be deducted from your business loan’s interest.
Small business loans can be harder to get than other loans, as they can pose a risk to lenders. Using a personal loan to fund your small business can also be filed under good debt, as the potential financial benefits are still the same. The interest on your personal loan can also be tax-deductible if the loan is used for business-related costs.
Getting an auto loan can be good debt if you qualify for a reasonable annual percentage rate (APR). It’s true that your vehicle’s value can drop as soon as you pull out of the dealer’s lot, but owning a car can make a positive difference in your life. Having reliable transportation can make it easier to get to and from work, or make getting a higher-paying job possible if you previously had transportation issues.
Risks Of Good Debt
Having good debt doesn’t guarantee an improved financial situation. Like all debt, there are certain risks involved. These can include:
- You may end up defaulting on your loan. The risk of taking out any loan is finding that you can’t afford your monthly payments, which can have major consequences. In the case of a mortgage, if you don’t budget correctly, or if you miscalculate what you can afford, you could end up defaulting on the loan and losing your home to foreclosure.
- You might not get a high-paying job after college. A higher education degree doesn’t guarantee you a high-paying job right out of school. You may have to take an entry-level job with lower pay in order to start repaying your student loans.
- Your business can take a long time to become profitable. Some businesses take time to grow and earn a profit, but in the meantime, you still have to somehow repay the loan you borrowed.
When deciding to take out any type of loan, weigh the risks against your current financial situation. It may just not be the right time for you to take on debt of any kind.
What Is Bad Debt?
Bad debt can drag down your credit score and finances, with little long-term benefit to you or your net worth. Additionally, bad debt can come with shorter repayment terms, making it harder to make all of your payments fully and on time.
Let’s take a look at some examples of bad debt.
Credit Card Debt
Credit cards can be known to have high interest rates – some over 20% – and can cost you more in the long run if you can’t make your payments every billing cycle. Using a credit card for numerous large, inessential purchases could make it difficult to repay the debt while interest piles on every month, and could set you up for years of credit card debt.
Payday loans are short-term money loans due to be repaid by your next paycheck, which is typically only 1 – 2 weeks from when you get the loan. Lenders charge high fees for payday loans, too, ranging $10 – $30 for every $100 borrowed, and APRs of around 300 – 400%. With such short turnaround time and interest rates that high, a payday loan could hurt your finances more than help them.
How To Avoid Bad Debt
There are a few steps you can take to ensure that you avoid taking on bad or unnecessary debt. Keep the following advice in mind:
- Choose your debts wisely. Review what separates good debt from bad debt, and whether you’d be setting yourself up for future benefits or financial hurt. You’ll also want to shop around different lenders to find the best deals on interest rates and terms.
- Only borrow what you can afford. Borrowing more than you can afford to repay can lead to years of being stuck in debt, or defaulting on your loan.
- Pay your debt off quickly. Once your debt is fully paid off, that’s one less bill to pay in your monthly expenses. Take steps to pay off your debt so you can better enjoy the benefits it brought you.
- Keep an emergency fund. Bad debt can often come about because you need cash for short-term or nonessential expenses, but it can also come from unplanned or emergency costs. Keeping an emergency fund for these instances can keep you from collecting bad debt and hurting your finances.
Debt can be good and it can be bad. The difference between the two can depend on what that debt can do for you in the long run. Good debt has the potential to improve your income and net worth, while bad debt can hurt your financial situation or put it at a standstill.
To prepare yourself for taking out a loan, learn about different types of debt and how to manage each kind.
Rocket LoansSM does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
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