Whether it’s using credit cards to pay for gifts or a student loan to pay for college, debt is incredibly common. According to Experian, one of the major credit bureaus, the average amount of debt per person was $101,915 as of 2022. This included debt from mortgages, student loans, auto loans, personal loans, and other kinds of debt.
Although debt can be stress-inducing, it’s not something that should be avoided at all costs. In some cases, taking on debt is necessary — and can even be beneficial. By understanding the differences between good vs. bad debt, you can make wise decisions about borrowing money and using credit.
What is “Good Debt”?
Whether debt is “good” or “bad” is largely subjective, and it’s not a moral judgment. Instead, the term means that “good debt” can help improve your net worth or cash flow over time. When used responsibly, good debt is a long-term investment in yourself and your future. Examples of good debt include:
1. Student loans
2. A mortgage
Buying a home can be a smart investment. Besides giving you a place to live and call home, the housing market has historically produced high returns. According to the National Association of Realtors, homeowners experienced median gains of $225,000 over 10 years.
Because real estate typically grows in value rather than depreciates, mortgages are types of good debt.
3. A refinanced or consolidated loan
When you refinance or consolidate debt, you take out a new loan to pay off your existing accounts. With good credit, you could qualify for a lower rate on the new loan.
Refinancing or consolidating existing accounts can be a type of good debt since it can help you save money and potentially pay off your debt faster.
4. Money borrowed to start a business
Entrepreneurship is increasingly popular. In fact, the Economic Innovation Group reported that nearly 1.7 million new business applications were submitted in 2022.
But starting a business can be costly. Taking out a loan to cover your initial startup costs is usually a type of good debt because with the right business plan and management, becoming an entrepreneur can grow your income and wealth.
5. Home equity loans or home equity lines of credit (HELOCs)
Over time, your equity can grow as you pay down the mortgage and home prices increase. A home equity loan or HELOC allows you to borrow against the equity that you built.
Whether borrowing against your equity is a form of good debt depends on its use; home equity loans or HELOCs used to pay for home repairs or renovations that improve your house’s value are typically considered good uses for the debt.
6. Medical loans
There may be times when you need a necessary medical procedure your insurance company won’t cover, or you may need money to cover your deductible or out-of-pocket costs.
Although medical procedures may not improve your earning potential or net worth, medical loans can be good debt if they are used for essential procedures that improve your health and quality of life.
What is “Bad Debt”?
Bad debt refers to debt that you use to buy depreciating assets or unnecessary expenses. These forms of debt often have high interest rates too.
Just because a type of debt is labeled as “bad,” that doesn’t mean you should never use it; bad debt can be useful and even necessary in some cases. But you should explore all of your options and look at alternatives before taking out a bad debt to avoid costly interest charges.
Some examples of bad debt include:
1. Credit card debt
If you carry a balance on your credit card, meaning you don’t pay off the statement balance every month by the due date, the credit card issuer will charge you interest on the remaining amount. Credit card annual percentage rates (APRs) can be extremely high; according to the Federal Reserve, the average APR was 20.92% as of February 2023, the last available data.
With such a high rate, your balance can grow from the interest charges, making it difficult to get out of debt.
Reduce interest charges by paying off the statement balance in full every month. If that’s not possible, try to pay more than the minimum required to cut down on the amount of interest that accrues.
2. Auto/car loan
Most people need to use car loans to purchase a new vehicle. In fact, Experian reported that over 80% of new cars are purchased with auto loans. And a car can be a necessary expense, particularly if you have to commute to work.
However, cars are depreciating assets. As soon as you drive the car off the lot, its value decreases, and it continually declines over time. And depending on your credit, you could end up with a high rate; rates can be as high as 13.42% for those with poor to fair credit. Over time, the APR and depreciating value can cause you to owe more on the loan than the car is worth.
To minimize the impact of a car loan, save enough money for a down payment, and pick a shorter loan repayment term of three to five years.
3. Payday loans
Payday loans are short-term loans for fairly small amounts, such as $500 or less. They’re intended to cover unexpected expenses or tide you over until your next payday. But the problem is they have sky-high rates and fees; according to the Consumer Financial Protection Bureau, the typical payday loan’s fees equate to an APR of nearly 400%.
Such a high rate makes it nearly impossible to pay off the loan on time, so many borrowers have to roll the remainder into a new loan. Payday loans can begin a cycle of debt that is incredibly hard to get out of, so explore all other options — such as a pay advance from an employer or asking friends or family members for help — before using a payday loan.
4. Personal loans
Personal loans are forms of debt you can use for a range of expenses. Because they have few limitations, you can use one to pay for a dream vacation or new furniture for your home. But taking out debt for unnecessary expenses can be a costly mistake. Personal loans can have high interest rates — some lenders charge as much as 35%. And the loan terms mean you could be paying for that vacation or furniture for years after the initial purchase.
If you can, saving the money and paying for those splurges in cash can be a more cost-effective option.
How to Spot the Difference Between Good and Bad Debt (and Avoid Bad Debt)
When determining whether a loan or line of credit is good or bad, ask yourself the following questions:
- Is this expense absolutely necessary? If you have an essential expense, such as a medical bill or car repair, taking out a loan can be a necessary step.
- How long will it take me to pay it off? Ideally, the loan should be repaid in a relatively short period of time. If you have to stretch out the loan term to make it manageable, it may be that you’re borrowing more than you can afford.
- Will this save money or earn me money over time? Loans or lines of credit that allow you to save money on interest or boost your earning potential are usually forms of good debt.
- What are the rates and fees? Some forms of credit have interest rates or APRs with double or even triple digits. These forms of credit can cost you a significant amount of money, and should be avoided if at all possible.
Understanding the differences between good debt vs bad debt can help you make informed choices about what forms of credit to use and which debt to repay first. But even good debt can get out of hand, so it’s important to borrow only what you need and keep your payments at a manageable level for your income.