When a lender looks at your credit report to see what kinds of accounts you have, they'll look at some debts more favorably than others. If you’re focusing on getting out of debt, you first need to understand which debts are considered bad and which are considered good. That way, you can prioritize your debts so that you get rid of the bad ones first.
What's the Difference Between Good and Bad Debt?
|Good Debt||Bad Debt|
|May be considered an investment||Not considered an investment|
|Used to finance things that will increase in value||Used to finance things that can be consumed|
|Examples include mortgages, student loans, and car loans||Examples include credit card debt and high-interest loans|
Defining Good and Bad Debt
Some of your debt might be considered an investment. You may be thinking, “How can anything as bad as debt be considered an investment?” If you took on the debt to purchase something that will increase in value and can contribute to your overall financial health, then it’s possible that debt is a good one.
When you use debt to finance things that can be consumed, you're taking on bad debt. It is the kind of debt that creates an unhealthy financial situation.
Examples of Good Debt
A mortgage: You build equity in your home, and the money you pay toward the home can be seen as an investment. Many people view renting an apartment as just throwing your money away, whereas you build equity when you purchase a home. However, this too can turn into a bad debt decision. If you borrow too much from your home or cash in your equity to buy things right away, then your mortgage debt is not good debt.
Student loans: This debt helped to raise your income potential, which can justify the need to borrow the money. The Department of Education estimates that those with a bachelor’s degree earn around $1 million more in their lifetime than a worker without a post-secondary education. But you still want to limit the amount of money that you borrow. You can sometimes roll bad debt into a student loan—don't borrow more than you need simply to have extra spending money.
You can deduct the interest you pay on your student loan from your taxes, even if you do not itemize, which may put paying off this debt towards the bottom of your debt payment plan.
Car loans: This can be good debt if you can get a reasonable annual percentage rate and the vehicle you purchase maintains its value after you repay your loan. Also, using an auto loan to get a vehicle could open up the possibility of getting better-paying jobs you might not otherwise consider because of transportation issues.
Examples of Bad Debt
Credit card debt: This is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never use debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, it should be intentional: to earn rewards knowing you'll pay off your entire balance on the due date, for example.
It may be tempting to put a vacation on your credit card because you've convinced yourself some time away can help you be more productive when you return. However, a vacation does not have appreciable value even if it does have legitimate benefits.
High-interest loans: Payday loans and certain personal loans can charge incredibly high interest rates. For example, the Consumer Financial Protection Bureau points out that some payday loans can charge APRs that approach 400% when you account for the fees you pay to borrow.
And while many personal-loan lenders advertise rates below 10% APR, they reserve those rates for borrowers with excellent credit. Personal loans for bad credit can have APRs over 35%.
How to Focus on Good Debt and Avoid Bad Debt
Getting into a habit of taking on good debt and avoiding bad debt takes practice and a shift in your mentality.
Good debt is obtained by making wise decisions about your future, not for the sole purpose of having good debt. For example, you might make the decision to obtain your master’s degree to increase your earning potential. Taking out a student loan, if you have no other way of financing your education, could be a valid reason for taking on additional debt.
Approach your debt payoff strategy wisely, too. It’s usually a good idea to focus on paying off your bad debts first since they may cost you more in fees and interest than your good debts and have very little appreciable value. You should pay off credit cards and auto loans before tackling mortgages or student loans.
Some people consider using good debt to pay off bad debt, like getting a mortgage for $110,000 instead of $100,000 and using the extra to pay off credit card balances. This approach may not be a good idea for several reasons:
- You’ll take longer to pay off your mortgage.
- The higher mortgage increases your monthly payments.
- The higher mortgage increases the time it takes to build equity in your home.
Pay Attention to How Much You Borrow
Your choices of how you spend your money relate back to whether or not a debt is considered good or bad. It is important to remember that any debt that is excessive or used to purchase wants instead of needs should likely be avoided.
Additionally, just because the debt is good instead of bad does not mean that you should borrow all of the money that is available to you.
Use good judgment when you make decisions to borrow money. You may regret purchasing a home if you end up being house poor as a result. It's advised to keep your debt-to-income ratio below 35% of your income.
And, as you consider taking on more debt to buy something, be intentional. Ask yourself the following questions:
- Will I have something to show for this money in the next year or five years?
- Is it something that I need immediately (such as paying for a car repair or a medical emergency)? Can I save up for it instead?
- Is there an alternative way to pay for this?
Pay Off Your Debt as Quickly as Possible
Even if the debt is considered good debt, you should work to pay off your debts as quickly as possible. It will allow you to begin to build wealth. It can also help you pursue your dreams because you will not be as dependent on your paycheck each month.
There are many reasons to get out of debt. If you are serious about getting out of debt, you will need to set up a budget and debt payment plan that allow you to apply additional money to your loans each month. You can pay off your debt quicker than you think if your money is managed correctly. It may mean taking on an additional job for a short period of time or cutting back on your lifestyle, but the sacrifices will be worth the effort.
The Bottom Line
Good debt is the type of debt that may be considered an investment, such as a mortgage, student loans, or an auto loan. This debt is taken on to purchase something that will increase in value or contribute to your overall financial health.
Bad debt, on the other hand, is used for purchasing material things. This includes credit card debt and high-interest loans. While bad debt might make you happy, it doesn't provide any type of return on your investment that puts you in a better financial position than you were before.
For most people, having some level of debt is almost impossible to avoid. But making smart choices about borrowing, as well as being aware of the "good" and "bad" types of debt, can help ensure your debt doesn't become overwhelming.