If you grew up being told to avoid debt at all cost, then you might consider all debt “bad” debt. In reality, things are rarely so simple, and it’s unlikely you’ll go through your entire life without having to borrow money at some point.
Truth is, there are some types of debt that are clearly bad for your financial health, while other types can be viewed as beneficial in the long run because they help you achieve goals that would have been difficult — if not impossible — to achieve otherwise.
Below, we explore the differences between good debt and bad debt to help you understand how each can affect your finances.
WHAT IS GOOD DEBT?
Good debt tends to have a low interest rate, and generally serves to help borrowers reach an important financial goal. It can also be viewed as an investment in the sense that whatever it is that you're borrowing for is ultimately intended to help you improve your financial situation.
Some examples of good debt include:
Student Loans. Student loans are commonly referred to as good debt. Federal student loans in particular tend to come with a low interest rate (5.05 percent on federal student loans for undergraduate borrowers as of July 2018) and help make a college education possible for millions of Americans. They can be viewed as an investment in your financial future because, with a degree, you’re potentially able to earn more money over the course of your career (by some estimates, as much as $900,000 more).
That said, student loans still weigh heavily on a lot of graduates, so it’s important that student borrowers try not to take out more than they can realistically repay. Private student loan companies may also charge you a higher interest rate than what the federal government offers.
A Mortgage. Buying a house is going to be one of the biggest financial decisions you’ll ever make — and it’s certainly not a purchase most people can pay for in full. Taking out a mortgage is what makes homeownership possible for the majority of people.
Mortgages also come with a few key financial benefits. They have generally low interest rates and could help reduce your tax liability thanks to the mortgage interest deduction. Plus, as you make mortgage payments, you’re increasing your equity in your home, which helps your net worth grow over time.
It is, however, possible to finance more home than you can actually afford. What that means for people really depends on their circumstances, but generally, many lenders may use the 28/36 guideline when assessing borrowers for a loan. This means they prefer that a borrower’s housing costs not exceed 28 percent of their gross income, and their total debt (including mortgage payments plus other debts) not exceed 36 percent.
WHAT IS BAD DEBT?
Bad debt typically provides no value back to you — and if anything, the purchases you make likely lose value over time, in addition to charging you high interest rates. Some examples of bad debt include:
Credit Cards. When used correctly, credit cards can be an easy and convenient way to make purchases while potentially earning rewards. The moment you find yourself carrying a balance from month to month, however, is when it can cross the threshold into bad-debt territory.
What makes carrying a credit card balance so bad for your finances? The high interest rates. The average credit card in the U.S. carries an annual percentage rate that’s above 17 percent — and it can go much higher. Carrying a balance means you’re paying more, often a lot more, than what you were charged because of this interest — with little to no investment to show for it.
Payday Loans. Payday loans aren’t just bad debt — they’re some of the worst debt you can take on. Interest rates can go as high as 700 percent in some states, and lenders may impose extremely aggressive repayment schedules. This can result in borrowers failing to repay their loans on time and being stuck with fees and interest accrual that's difficult pay off.
WHEN GOOD DEBT GOES BAD
Not all debt can be easily categorized. Auto loans, for instance, can be a gray area. On the one hand, an auto loan helps you purchase a vehicle that you need to go to work, complete everyday tasks or take care of your family, and their interest rates are typically low. But when you purchase a new car, the vehicle can lose as much as 10 percent of its value as soon as you drive it off the lot — and as much as 20 percent within the first year you own it. Plus, you may end up financing more car than you can afford, which can be detrimental to your finances.
What's important to remember is that all debt — even good debt like student loans or a mortgage — has the potential to become bad debt if it’s not managed responsibly. A financial professional can help you assess how much debt you can reasonably take on and work with you on strategies for paying it down so that your financial health stays intact.