Personal Finance

Good Debt vs. Bad Debt

Debt is something we all want to avoid, but it is often inevitable. Here we take a look at good debt and bad debt and the difference between each.

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Avoiding debt is a noble goal. And while it’s wise to reduce the amount of debt you carry, that advice tends to simplify the concept of debt into a single lump of undesirable financial burden. When really, there are two types of debt good debt and bad debt.

Debt holds no moral leanings. It isn’t inherently good or bad, but it is a product of your decision-making and life circumstances. The type of debt you carry with you can impact your financial wellness in the future. Obviously, if you must have some type of debt, you’ll want to strive for the good kind.

What Is Good Debt?

Good debt is money you have to borrow today that will produce greater returns in the future. Put simply, it’s a debt, or liability, that will eventually convert into an asset, or increase your net worth.

Mortgage

Say you take out money to buy a home. Technically, this is a liability because it’s debt that drains your income every month. But, if you’ve strategically purchased a home while rates are down and in an area where real estate pricing is depressed, then that debt can turn into your profit when your home increases in value and you sell.

Furthermore, owning a home opens the door to using a home equity line of credit. Responsibly using this credit line can help you pay off bad debt and high-interest rates at a much more appealing rate. Be cautious about opening a HELOC, however. You may be risking foreclosure if you fail to pay.

Student Loans

Student loans have seen the largest balloon in growth when compared with other types of debt, according to data reported from Experian. With the cost of attending a university continuing to skyrocket, it’s fair to wonder if getting a bachelor’s degree is still worth it.

And the answer is still empirically, yes. A recent study from the Federal Reserve Bank of New York shows that the average bachelor’s degree holder earns $78,000 annually. Compare that to the $45,000 annual salary of the average high school graduate with no college degree, and the numbers speak for themselves.

For those of us who like to look at long-term investment returns, consider this: The S&P 500 returns an average of 9.5% per year when analyzing the period between 1928 and 2015. In comparison, a college degree provides returns of 14% per year, even when the rising costs of college tuition are taken into account. Those gains classify your student loans as a good debt.

Small Business Loans

Spend money to make money is a scary mantra for the financially conservative among us. But when it comes to growing your own small business, the startup costs are going to stack up before the profits hit your bank account. For this reason, a small business loan may be a necessary and good debt to fund your business so you can reap the net benefit in the future.

However, small business loans are known for being difficult to obtain. A lender may require you to provide tax documents and a business plan, and they may assess your personal credit. Our Best Small Business Loans guide breaks down the right type of loan for your business as well as how to prepare before applying.

What Is Bad Debt?

If your debt isn’t working to earn you money at a later time, then it’s most likely bad debt. These expenses are bad for two reasons:

  1. They drain your income and asset columns (and don’t forget the interest hit) without a return.
  2. The expense is nonessential, meaning it was used to purchase something that wasn’t necessary to continue functioning.

Bad debt touches on our psychology and behavior when spending money or credit on a want instead of a need. With credit, we all have access to commodities that represent the lifestyle we want, regardless of the lifestyle we can actually afford.

High-Interest Credit Cards

With just a quick swipe, we can have anything we desire that costs less than our credit limit. That could be any luxury item or experience-designer belts, virtual reality games, resort vacations basically any product that’s fun and exciting and of top-of-the-line quality.

While those things may be thrilling at the moment, paying high interest on those purchases once your credit statement comes is a real downer. High-interest credit cards are considered bad debt because they siphon away our available income, plus some for interest, without ever putting any funds back.

Keep in mind, just because an item might result in bad debt, doesn’t mean the item is inherently bad. If your income can afford these expenses without going into debt, it’s perfectly fine to splurge and indulge. If you’re drawn to luxury items and can’t resist putting yourself in debt, then consider assessing your spending habits.

Predatory Payday Loans

So, you’re in a bind. You don’t get paid until next week, the electric bill is due, your family needs to eat, and what’s left in your bank account won’t cover it. In times of dire need, folks may turn to a payday loan, even knowing that an astronomical interest rate will be due on top of the amount borrowed.

As the Federal Reserve puts it, The annualized interest rate for a payday loan often exceeds 10 times that of a typical credit card, yet this market grew immensely in the 1990s and 2000s, elevating concerns about the risk payday loans pose to consumers.

A payday loan can often reach an APR of 400 percent. Instead of accepting the quick cash, there’s almost always a better way to get by until your next paycheck hits your bank account, even if that means taking out a personal loan or charging a traditional credit card. See our payday loan alternatives guide for better options to suit your situation.

Auto Loans

Auto loans are on the rise. In the last quarter of 2020, auto loan balances in the United States increased by $14 billion, the second-highest quarter since 2000.

Your car may seem like a necessary expense. And for many, it is. It’s the transportation that makes it possible for you to get to your job to earn income. So, why is it considered a bad debt?

As we all know, once those tires leave the car dealer lot, the depreciation race begins. Because automobiles often depreciate in value as you pay down your loan, they cannot be placed in the asset category. In the worst-case scenario, you may even end up upside down on your loan and owe more than the car would sell for on the market.

Depreciation doesn’t negate the fact that many still need a vehicle to reliably make it to work every day. But, here’s where the human element of want vs. need comes in. There’s not a real need for a luxury vehicle with a TV in the console nor do most people need an SUV made from kevlar that can handle open warfare to get to their office job. These are wants that vastly increase the loan amount on the vehicle.

If, however, you save for a car that can reliably get you to and from work without the extra bells and whistles, and for a loan amount that you can easily pay off, this would not be considered a bad debt.

Shopping around for auto loan rates is easier than ever with the internet. Loan aggregators like Monevo make it easy to look at potential rates from several lenders at once. Read the full Monevo review

How the Pandemic Has Affected Our Bad/Good Debt Balances

The total consumer debt carried by the average American is $92,727 at the end of 2020, as reported by Experian, which supplies credit and debt data to the U.S. Federal Reserve.

The debt balance has not been this high since 2010, when we were fresh off another economic recession. Unsurprisingly, the pandemic has likely been the cause of many Americans turning to debt to get by, as many were faced with unemployment challenges.

The silver lining is that economic pandemic assistance may have helped us lower debt in the bad debt categories. For example, average credit card debt fell by 14%. In the good debt categories, student loans and mortgages saw an increase throughout the past year. In the age of coronavirus, were seeing less credit card swiping and more home-buying and higher education pursuits.

Debt Is More Neutral Than Good or Bad

Before you swear off bad debt forever, it’s important to recognize that you can put bad debt to good use. Bad debt can be part of a financial strategy, such as using credit cards that you responsibly pay off every month for cash back. This makes a bad debt financially beneficial to you and transforms it into a good debt.

And good debt can just as easily cross into bad debt territory. For example, if you spend your four years in college pursuing a degree in Prussian literature, you likely won’t see the return benefit as someone who goes into a more economically in-demand field. Kudos for investing in your passion, but passion investments may not cover the student loan bill.

It’s all in how you structure your financial strategy and make spending decisions, which can mutate a good or bad debt into its opposite.

Bottom Line

The examples above show the many holes that can be poked into the good and bad dichotomy of debt. It’s vital to consider your unique financial circumstances and goals when determining which types of debt will benefit you the most. These broad strokes of debt categorization can be useful guidelines, but don’t fall into the trap of organizing all your debts into one of these categories without assessing the nuance of your unique financial picture.

And, if you want the simplest answer, just go back to the age-old advice and live within your means by staying away from all debt whenever possible.


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