One of the biggest throwdowns in the world of personal finance is the idea of good debt vs. bad debt.
While there are some who believe that there is no such thing as good debt, the reality is that sometimes debt can be a tool to help you advance your personal finance goals. The key is to use debt smartly and judiciously.
The truth is, any debt can be bad or good when the person taking on the debt doesn’t understand the debt they are taking on and how they will pay it off. While mortgage loans are considered good debt, if you buy more house than you can afford or take on creative financing like an interest-only mortgage, suddenly a mortgage becomes a bad debt.
Let’s take a look at the different types of debt and what you need to know to keep good debt from turning into bad debt.
What Is Good Debt?
In general, good debt is debt that moves you forward, helping you reach financial goals or ultimately better your situation. Additionally, in some cases, your good debt will come with a tax deduction. However, it’s important to be careful of good debt. It’s possible that your good debt could turn bad if you take on too much, or if you don’t have a solid plan to pay it off.
Student loan
An education can potentially help you get a good job and meet your income goals. However, it’s important to be careful with student loans. First, try to save up as much as possible, apply for scholarships, and consider getting a job and working while you’re in school. All this can help you reduce how much you borrow. Additionally, carefully think about what your salary is likely to be so you can avoid getting deep into debt in a field of study that won’t allow you to effectively tackle your payments later.
Mortgage
Few people can afford to pay hundreds of thousands of dollars in cash for a home. As a result, a mortgage can make sense. Try to keep your total home payment costs, including taxes, insurance, and interest, to less than 30% of your take-home pay. Even though a home can be a good financial asset, you don’t want to be house poor or take on more debt than is feasible for your monthly budget.
Car loan
Be careful about the car loan. In some cases, a modest car loan to help you afford reliable transportation to and from work can make sense. However, it’s important to borrow as little as possible and pay off the debt as quickly as you can. Then, you can save up for your next car.
What About Other Debt?
Some debt we may have heard is bad can be good debt in the right circumstances.
Generally, bad debt is consumer debt that doesn’t offer you the ability to move forward with your financial goals or help you improve your situation. A lot of the time, bad debt also comes with higher interest rates. While you might be able to get a student loan or car loan for less than 5% APR, bad debt often comes with high rates.
Credit cards
Credit cards can get a bad rap, and for good reason. People may over-use credit cards, buying consumer items that they don’t need or that lose value quickly.
When you run up large credit card bills and carry a balance, you can pay high interest rates that can weigh on your finances.
How to make it a good debt:
- If you use credit cards, try to avoid carrying a balance.
- If you find yourself in debt, consider looking for a 0% balance transfer card that will let you pay down your balance quickly.
- Use a good credit card that offers cash back or travel rewards.
Payday loans
These loans can be a good emergency measure, but they can trap you in a cycle of debt that can be difficult to get out of. Interest rates are very high and it’s easy to extend a payday loan due date by paying a fee. In some cases, APRs can exceed 500%.
How to make it a good debt:
- If you have a payday loan, try to find ways to earn more money or cut back on expenses so you can pay it off as quickly as possible.
- If you find yourself needing to resort to payday loans on a regular basis to get by, speak to a nonprofit credit counselor and work on a budget that will keep you from needing that payday loan.
Where Do Personal Loans Fall?
Unsecured personal loans can be a powerful tool in helping you meet your goals, both financial and otherwise. As with mortgages, car loans, student loans, or any other type of debt, you should understand the terms of your loan and have a clear path for paying back the loan. If you can’t afford the monthly payments, you’ll end up in more trouble down the road.
Personal loans can be good debt and valuable financial management tools if you are using them to get rid of high-interest credit card debt, or if you are consolidating debt. Additionally, a low-interest personal loan can be a lifeline if you need money for something important like medical treatment or if you have a short-term cash flow issue.
If you are considering a personal loan, create a plan on how you will responsibly manage that debt, make your payments on time, and pay your debt in full.
Good Debt vs Bad Debt FAQ
Is debt a good or bad thing?
Debt by itself isn’t necessarily good or bad. Depending on your situation and goals, debt can help you improve your situation. However, it’s possible for good debt to turn bad if you borrow more than you can afford to pay for school or get a bigger home. Don’t borrow more than you need, and have a plan to pay it down.
What is considered good debt vs. bad debt?
Good debt is generally seen as debt that can help you acquire an asset, like a home, or improve your situation, like an education. Sometimes business debt is considered good debt because it can help you create revenue.
On the other hand, debt that doesn’t help you improve your financial situation is often seen as bad. Getting into debt for consumer items and other non-essentials can become overwhelming if you don’t have a clear path and plan to pay back that debt.
How much debt is normal?
According to Experian, the average American has $92,727 in debt, including mortgage, car loans, student loans, credit cards, and more. However, just because it’s normal to have debt, it doesn’t mean that you should stay in debt. You’re more likely to achieve your goals of financial freedom if you focus on keeping your balances low, making your payments on time, and setting money aside in a savings account for emergencies.
