Good Debt vs. Bad Debt
Many people strive to get out of debt, but did you know that some debt can actually be beneficial? In this article, we’ll explore good debt vs. bad debt, how each type affects your credit history, and how to pay off bad debt.
What is good debt?
In general, good debt is any credit agreement you’re able to responsibly repay because it strengthens your FICO credit score. Many financial experts, however, consider good debt to be any type of loan used to build long-term wealth.
Types of good debt
A few debts are worth taking on because they can eventually help boost your income or offer a return on your investment. Some types of good debt include:
Building wealth through real estate is nothing new. The idea is to purchase a house with a mortgage, live in it long enough to build equity, and then sell it at a profit. You can also supplement your income with rental property. In either case, you’ll need a mortgage to jump on the property ladder.
Home equity loans
Home equity loans or lines of credit that tap into your home’s value can be considered good debt when you use the funds to make home improvements or upgrades. Just be sure you can afford a second mortgage before tapping into this financial resource.
Higher education often leads to more earning potential. However, unless you score a full-ride scholarship, you’ll probably need to pay for college with student loans.
Student loans are considered good debt because they’re an investment in your future career. With a college education, you’ll have a better chance of landing a good-paying job and any subsequent promotions.
Keep in mind, though, that not all college degrees are equal. An engineering major, for example, can earn substantially more in their lifetime than someone who majors in social work. Of course, this doesn’t mean you shouldn’t follow your dream, but if you do plan to enter a lower-paying career, you might want to steer clear of more expensive universities so that you don’t graduate with excessive student debt.
Small business loans
If you have a solid business plan and a clear vision, borrowing money to start a business is a type of good debt that can pay off a great deal.
Of course, since only around half of all small businesses survive beyond the five-year mark, starting your own business is risky. Still, if your company does succeed, any money you borrow to get there will be worth it.
What is bad debt?
A bad debt is generally considered a loan you use to purchase a depreciating asset. While going into debt for a mortgage or education has the potential to earn you more money than you originally borrowed, bad debts don’t have this perk.
This isn’t to say you should avoid all types of bad debt. In fact, borrowing money from these sources will establish your credit history and grow your credit score if you’re responsible. Treating bad debt responsibly can also make it easier to qualify for certain good debts down the road.
Types of bad debt
Some commonly used bad debts include:
Credit card debt
Using credit cards is a great way to establish a strong credit history. However, if you can’t pay your credit card balance in full every month, the added interest can keep you in debt indefinitely.
A vehicle depreciates in value the second you drive it off the lot. This means that when you take out an auto loan, you automatically owe more than the car is worth.
Still, since most people don’t have enough cash on hand to buy a car, there are plenty of circumstances when this type of bad debt is necessary.
For instance, you probably need your own car to get to work or college. Without an auto loan, you can’t further your career prospects or earn income. That debt then becomes an investment in your livelihood regardless of the vehicle’s depreciation.
When taking on this (or any) type of bad debt, it’s essential to only borrow what you can afford to repay, even if that means settling for a used car.
Differences between good debt vs. bad debt
An excessive debt of any type can cause financial strain — but understanding the key differences separating good vs. bad debt can help you make smarter financial decisions. So, before taking on any debt, keep these differences in mind:
- Good debt finances a service or item that increases in value over time; bad debt funds a service or item that depreciates in value.
- Good debt can generate a return on your investment; bad debt causes you to lose money.
- Good debt is a reasonable loan amount you can repay; bad debt is a loan you struggle to afford.
It’s also important to remember that any type of good debt can become bad debt if it’s poorly managed. On the flip side, bad debt that gets you out of a short-term cash crunch can be a good decision when you repay the debt in full and on time.
Can I have both bad debt and good debt?
You can have both good and bad debt. In fact, most people will have both types of debt at some point. This is especially true when trying to establish your credit history or improve your credit score, as it’s easier to qualify for credit cards, lines of credit, or store credit cards than a mortgage or auto loan.
How to pay off your debt
If you want to pay down debt — or get out of debt altogether — you’ll need to tackle those bad debts first. Here’s an example of how to approach debt repayment with a mix of good and bad debts:
1. Figure out how much you owe
The first step is to take stock of what you owe. Listing your total balances, monthly payments, and interest rates can help you prioritize debts.
2. Prioritize highest-interest debts
Bad debts tend to have higher interest rates. So, in addition to making regular monthly payments, pay extra on your highest-interest-rate debt until it’s paid off. Then, focus on the next-highest-interest debt, and so on.
3. Cut back on non-essential spending
When actively trying to get out of debt, avoid non-essential purchases like clothing and other splurges that would take away funds you could otherwise put toward debt.
4. Keep paid-off accounts open
Once you’ve repaid a debt, don’t close the account. Keeping the account open helps your credit score by boosting your debt-to-income ratio and preserving the length of your credit history. Worried that you’ll be tempted to charge unnecessary purchases to a paid-off credit card? Keep the card stored safely at home, not in your wallet.
Understanding the differences between “good debt” and “bad debt” can help you create a more effective debt-repayment strategy. Check out our blog for helpful ways to manage debt and increase your savings.