The Difference Between Good Debt and Bad Debt

The Difference Between Good Debt and Bad Debt

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When most people hear the word ‘debt’, they imagine sleepless nights spent worrying. But debt is debt; it’s not inherently good or bad. In general, however, most personal finance experts agree that taking on certain types of debt can lead to better outcomes than others.

Borrowing money, no matter the scenario has its risks. Sometimes taking such a chance ends up damaging your credit score and creating other issues over the long term. After all, frequently, reputable lenders aim for a mutually beneficial transaction. They want you to afford the monthly payments.


Naturally, the distinction between good and bad depends on the type of debt incurred. There are student loans and credit card debt, for instance. Plus, there are mortgages for buying a home and an auto loan when purchasing an automobile. And some will tell you it’s impossible to start your own company without small business financing.

Read on as the financial sages behind MoneyWizard explore debt—both good and bad.

What Is Good Debt?

Realistically, it all comes down to how the borrower leverages the transaction for something to be considered good debt.

If the debt turns out to be something that generates a return or betters your finances in the long run, it’s good debt. Keep in mind, it takes money to make money. Sometimes, to bolster your net worth, it means taking out loans or lines of credit.

While good debt has the potential to increase a person’s net worth, it’s generally considered to be bad debt if you are borrowing money to purchase depreciating assets.  The caveat is that you need to perform due diligence to ensure that you choose a sound option.

Here are some examples of debts that tend to generate a net positive for borrowers:

Student Loans 

Most frequently, education increases your earning potential and helps you find employment. Therefore, investing in your degrees and diplomas tends to generate a return within a relatively short time after starting your career.

Your decisions are vital in taking on and paying off student debts—namely, with the degree you select. Do the research and figure out employment rates and average salaries of the people who’ve embarked on similar educational paths. Provided you’re developing skills in something with minimal income potential, you’ve now taken on an unadvisable debt.

Home Equity Loans 

Homeowners are often advised to borrow money against their house to pay off non-mortgage debt. These are referred to as home equity loans, which frequently have preferable interest rates to credit cards or payday loans.  All the same, banks are allowed to raise interest on these loans—plus, they can demand payment whenever they want. What’s critical with these types of loans is to avoid treating your home as an ATM and ensure you remain disciplined in paying it off.

Other Examples 

The only way most people will ever own a home is through a mortgage. This option is a good debt on the surface since you can now build equity and gain a return on your investment. Such profits wouldn’t be possible when paying rent. But there are caveats here. If job security is an issue or the terms are too expensive, mortgages can quickly turn ugly.

Small business loans are often seen as good debts since they allow you to start significantly earning when properly leveraged. They’re usually offered with favorable interest rates, meaning generating a return is far less daunting. Of course, there’s still risk in that owning a company often ends in failure. But anyone confident in their business model should consider taking out a small business loan.

What Is Bad Debt? 

When you take out a loan or credit to purchase something that won’t give you any return—and will likely depreciate over time—it’s bad debt.

These are more expenditures than investments, and you’ll have to rely on your earning potential and other assets to make up the difference. Here’s a list of what’s considered bad debt.

Credit Card Loans 

Almost everything you’ll purchase on your credit card will depreciate over time. Furthermore, the interest rates are comparatively sky-high. Thus, the longer you carry a credit card balance, the more damaging it is.  Unsurprisingly, most experts suggest paying off your credit card balance in full each month. Letting it carry over means mounting interest expenses preventing you from building your nest egg. 

Payday Loans 

“Bad” might understate just how ill-advised it is for borrowers to take out payday loans. These are best described as predatory—sending vulnerable people into ceaseless cycles of debt. In short, the interest rate charged on these loans would make Tony Soprano blush, averaging 391% in the US.  Payday lenders tend to lure financially precarious people because they don’t perform credit checks.

Other Examples

Sometimes there’s no other choice—but taking out an auto loan is seen as bad debt. First and foremost, cars immediately begin to depreciate the moment you get behind the wheel. Moreover, such interest rates tend to be less than ideal. Generally, it’s suggested to purchase a used vehicle you can afford out of pocket instead of incurring car debt.

Consumer or personal loans might also be necessary if only to cover expenses during some financial turbulence. Still, the APR tends to be unforgiving, and you’re not earning anything back on your investment. While you might need to incur this kind of debt at some point, do so sparingly.

How To Use Debt To Your Advantage 

Ask yourself one question before incurring more debt: Will you eventually profit off this purchase? Provided that’s not possible, it means you’re taking on bad debt. Meaning that you should wait until you have the available cash. So, don’t put your facelift or gym membership on your credit card, for instance. In short, you want to maximize your good debt and neutralize your bad debt.

Other Considerations

It’s worth noting that bad debt can be unavoidable. Also, using your credit card, for instance, has its advantages when you’re consistent with paying off your balance. Namely, you’ll increase your credit score. What matters most is crafting a financial strategy that helps you avoid mounting your bad debt. You don’t need to be perfect—you merely must limit your mistakes.

Your credit score can have a big impact on your financial future. Sign up for Experian to get your credit score and credit report for free! Join millions of other Americans and get the tools you need to help understand, manage, and master your credit—in under 3 minutes. Checking your credit score with Experian won’t hurt your score.


Money-Saving Resources

Why Your Credit Score May Drop After Paying Off Debt
Explore The Pros and Cons of Personal Loans
Are You Carrying Too Much Debt?
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