Good debt vs. bad debt: Learn the difference

Debt, whatever type of debt it is, works the same way. You’ve borrowed money from someone else and need to pay it back. However, not all debt is a bad thing. While owing money to another person might not be a great feeling for most people, reaching the next level of financial fluency requires understanding the difference between good debt and bad debt.

In general, good debt is a debt that helps you purchase an asset or tool that will improve your financial future by growing your wealth. Bad debt does the opposite, draining your financial resources over time.

Key takeaways

• Having debt means owing someone money, but not all debt is necessarily a bad thing.
• Some debts can be good, helping you grow your wealth over time.
• Bad debt, which drains your financial resources, should be avoided.

What is good debt?

There isn’t a singular answer as to what constitutes good debt. Some people may argue that there isn’t any such thing as good debt in the first place, but managed debt is a tool that can have good effects if used wisely.

In general, good debts are those that help the borrower build wealth, either by acquiring an appreciating asset, improving themselves, or buying an essential tool for future financial gain.

Good debt is usually associated with lower interest rates than bad debt, making it more affordable.

Mortgage loans

A classic example of good debt is a mortgage loan.

The reason mortgages are seen as good debt is that they let you start building equity in your home. Rather than giving money away in the form of rent, you’re putting at least a portion of your housing payment toward something that boosts your wealth.

Down the line, you access the equity you build in your home several different ways. You can sell your home and use the money for other purposes. You could go a different way and continue to own the home but take out home equity loans or home equity lines of credit and use that money for home improvement, consolidating other debt, and for other reasons.

Mortgage interest rates tend to be quite low compared to rates for other types of debt. In some cases, you can even deduct the interest paid on mortgages and home equity loans, making them even more affordable.

Student loans

Student loans can be another form of good debt, though that can be a somewhat controversial opinion.

Student debt can help you cover the costs of attending college, getting a valuable education that can vastly increase your earnings potential. Earning a bachelor's degree increases the typical worker’s earnings by a substantial amount. Men generally make $900,000 more in median lifetime earnings than a high school graduate, while women with bachelor’s degrees earn $630,000 more than the typical woman with a high school diploma.

At the same time, overpaying for college can leave you mired in a large amount of debt that can be difficult to surmount. Prospective students and their parents should carefully research the payment expectations of student loans and how long they will take to repay. Understanding how these loans work can be tricky, but it is important to make sure the student loans you take on are a form of good debt rather than bad debt.

Small business loans

Many people have ideas for small businesses but can’t afford the start-up costs associated with building their own company. Similarly, many small business owners want to expand and look for the best ways to finance their business if they don’t have the savings to do so on their own.

Small business loans can provide the funds necessary to buy expensive equipment, rent a location, or hire more workers, which helps business owners grow their companies.

These loans can be risky for lenders, so rates are often higher than they are for other types of loans. The business owner also usually has to accept some personal risk if their business goes under. Keep in mind, generally you don’t pay taxes on personal loans. You may even be able to deduct the interest on a personal loan if the money is used for certain types of expenses. Check with a tax professional to get more detailed information.

Auto loans

Auto loans are unusual. They’re used to purchase a depreciating asset, which is typically associated with bad debt. However, for the vast majority of Americans, a car is an essential tool for getting to and from work, as well as handling daily errands like buying groceries.

When you buy a car, you may want to consider financing the purchase different ways to see how much you will pay in interest over time. If you’re weighing a personal loan vs. a car loan, research different lenders for both loan types to compare the terms to secure the best deal. When you get different loan offers from lenders, you can look at interest rates, the length of the loan, and the APR (annual percentage rate) to see which loan makes sense for your personal situation.

To make sure the loan you use for a car purchase is a form of good debt, buy a modest car that is within your means rather than a luxury vehicle. You can also lower the total amount you borrow by making a larger down payment on your vehicle.

With the purchase of a less expensive new car or used car with a lower price, you may also be able to buy the car outright for cash without having to take out a loan. Be sure to consider all the possibilities and your financial goals when making a choice that’s right for you.

Risks of good debt

Good debt is still a form of debt. You owe someone money and have to pay it back, and there are risks associated with that obligation.

Some of the risks of good debt include:

• Putting your finances and credit at risk. If you miss payments or default on a loan, you’ll damage your credit score. In some cases, you could also face financial damages. For example, if you can’t afford your mortgage payments, the lender could take your home.
• College isn’t a sure thing. While the typical college graduate vastly out-earns someone with a high school diploma, nothing in life is certain. Your grades, choice of major, the economy, the market for your specialty, and even just bad luck could lead to poor job prospects after you graduate, leaving you with debt and not much to show for it.
• Many businesses fail to become profitable. If you start your own company, there’s a good chance that it will fail. 18% of companies fail in less than a year, while half fail within five. If your company isn’t one of the ones that makes it, your business loan could do more harm than good to your finances. Before you take out a loan, be sure to understand the different kinds of loan options available to help you make the best choice for your personal circumstances.

What is bad debt?

If good debt is a tool that improves your financial situation over time, bad debt is the exact opposite. Bad debt is a drain on your finances, leaving you worse off than you were before you took it on.

In general, bad debts are associated with shorter repayment terms and higher interest rates, especially for those with poor credit scores.

Credit card debt

Credit card debt is the classic example of bad debt. Credit cards let you buy something now and pay for it later. If you choose to only make the minimum payment, you’ll find yourself paying interest rates that can exceed 20% and taking years to pay off the purchase.

This doesn’t mean you should avoid having a credit card at all. They can be a good tool when used properly, and you pay the bill in full each month, but avoid using the card for large charges you can’t pay off or for nonessential purchases.

Payday loans

Payday loans are a type of predatory loan that is aimed at people who need cash as quickly as possible. In effect, you’re borrowing money against your next paycheck and paying huge fees, sometimes reaching effective interest rates as high as 100% or more.

Because of the predatory nature of these loans, where you can pay as much as $10 to $30 for each $100 borrowed, they are illegal in many states. You should avoid these types of loans at all costs because it is very easy to get sucked into a nearly inescapable cycle of debt.

How to avoid bad debt

If you want to avoid bad debt, follow these tips.

• Choose debts mindfully. Before you apply for a loan, think about how it will impact your finances in the long term. Also, make sure to shop around to find loan terms and rates that keep the cost of borrowing low.
• Borrow what you can afford. Before getting a loan, make sure you assess your financial situation and understand whether you can handle the payments.
• Pay debts on time and try to pay them off quickly. If you have credit card balances or other types of debt, you may be wondering how to pay off debt fast. Be sure to never miss a payment on your loans. Set up automatic payments if possible. If you have extra money that you can spare, consider using it to make extra payments to pay down your debt faster.
• Build an emergency fund. Set aside extra money each month to deal with unexpected bills and financial emergencies. Once you look at your personal finances, you will need to consider how much your emergency fund should be to cover your monthly costs if you should suddenly lose your income. Having savings can also help you avoid turning to debt to pay an unexpected bill.

The bottom line: Use good debts to build wealth and net worth

In some cases, debt can be a good thing, helping you buy an appreciating asset and improving your financial situation over time. Knowing the difference between good and bad debt will help you make better financial decisions going forward.

Find out what you can be preapproved for with Rocket Loans today.

This article is for informational purposes only, and is not a substitute for professional advice from a medical provider, licensed attorney, financial advisor, or tax professional. Consumers should independently verify any service mentioned will meet their needs.