What Is Bad Debt? [And Why It Matters]
Though the line between good and bad debt can get fuzzy, there are some things that differentiate the two.
Taking on debt can be a helpful way to increase your earning potential, grow passive income, or otherwise invest in a financially stable future. Sometimes, it’s just necessary to protect your health or wellbeing. When managed responsibly, this good debt—like student loans and mortgages—can also help you improve your credit score.
In contrast, bad debt comes with high interest rates and doesn’t contribute to your bottom line in a positive way. Things like auto loans and credit card debt can be expensive to borrow and aren’t long-term investments.
Of course, there are a few gray areas and it may not always be clear whether debt is good or bad. If you’re thinking about taking out a loan for anything from minor necessities to a new car, take a careful look at your finances to determine whether it’s worth the risk.
What’s the Difference?
Though the line between good and bad debt can get fuzzy, there are some things that tend to differentiate the two. Things to consider when comparing good debt vs. bad debt include:
- Does the debt still make sense after considering the total cost of the loan? (Think: fees, principal, interest, and any lost investment opportunities)
- Along the same lines, is there a better way to spend or invest the money that will help you in the long term?
- Is this an investment that will produce long term yields or just a short term solution?
- Will you get more from the debt/expense than you put into it?
What is Considered Good Debt?
While some might argue there’s no such thing as good debt, taking out loans can still be a smart investment in your future. In general, good debt is that which increases your net worth or otherwise helps generate value. Good debt also typically comes with a lower interest rate than many types of bad debt. This means you can pay off the loan more quickly and at a lower overall cost than high-interest debt.
Keep in mind, though, that you should still try to keep even good debt to a minimum—especially if you have dreams of financial independence or early retirement.
Common types of good debt include:
Education costs—especially those related to postsecondary education—are generally classified as good debt. This is primarily because a degree, though expensive at the time, increases your long-term earning potential.
However, some degrees have a greater value than others. For example, Google offers affordable design and coding certificates that can land you a six-figure salary, while a $200,000 degree from a traditional college might limit the average student to substantially lower earnings. Don’t get me wrong—this doesn’t mean one degree is better than another. But from a debt perspective, it’s best to balance the cost of a degree against your likely earning potential.
But keep in mind the difference between medically necessary treatment and more elective surgeries. Whether medical debt is good or bad will ultimately come down to your individual circumstances. But if you need to go into debt to afford a procedure that will save or improve your life, it’s a worthwhile investment.
A home mortgage is often the largest loan someone takes out in their lifetime. Though daunting, shouldering this debt can be an investment in both your present and your future. For this reason, home mortgages are generally classified as good debt. Likewise, debt associated with investment properties can put rent payments in your pocket each month while acting as a long-term investment—both signs of good debt.
Building equity in a home also gives borrowers access to a home equity line of credit (HELOC) or home equity loan, both of which can be responsible alternatives to more expensive forms of debt.
Buying a house can be an excellent way to invest in your future. But for some, renting may still be the best option—especially if you’re investing the money instead of saving for a down payment. As with other forms of debt, it’s always best to evaluate your individual circumstances before signing on the dotted line
Though never easy, starting a small business can be an incredibly lucrative investment in your financial and professional future. Plus, with more uncertainty in the job market than in recent history, owning your own business is one way to invest in yourself and limit your risk of getting laid off. And the numbers back that up—in the wake of COVID-19, applications for new businesses are increasing more than they have since 2007.
Business loans are considered good debt if they increase your earning potential or otherwise improve your bottom line. These loans can also reduce your reliance on an employer, and have the potential to lead to more robust and sustainable income.
Remember, however, that starting a business can still be a risky venture and your investment isn’t necessarily safe. When deciding whether to take out a business loan—and whether it will be more good debt than bad—stick with loans that will help you generate increased income for your business.
So What is Bad Debt Then?
Generally speaking, bad debt does not generate long-term income or otherwise increase your net worth. Often used to purchase goods or services that do not have lasting value, bad debt presents less investment potential than good debt. Oftentimes, bad debt is associated with financing clothes, cars, electronics, and other consumer goods and services that lose their value quickly. Plus, bad debt frequently comes with higher interest rates, making it harder and more expensive to pay off.
Cars are one of the more famously depreciating assets because of their high upfront cost and rapid depreciation once driven off the lot. For this reason, financing for a new car is generally considered bad debt. What’s more, some auto loans come with high interest rates, especially for borrowers with a poor credit score or limited cash for a down payment.
Note that car loans can fall into a gray area, depending on the needs of the borrower. If you’re financing a sports car to use on the weekends, you’re likely dealing with bad debt. However, if you live in an area without public transportation or bikeable roads and need a car to get to your job, you can think of a modest car loan as an investment in your future success. In that case, just try to keep your interest rate low and buy a used car rather than a new model that will depreciate on day one. Additionally, once you do purchase the car, drive it until the wheels fall off —AKA get your use out of it! Avoid succumbing to lifestyle creep as much as possible.
Cash Advance Loans
Cash advance loans are bad debt because of their high interest rates, fees, and short payback periods.
If you’re feeling strapped for cash and are considering a payday loan, consider asking your employer for a paycheck advance, borrowing money from friends and family, or working with a local credit union to find lending terms that fit your needs.
By the end of 2019, consumer credit card debt reached a record high of $829 billion, with the average American facing $6,194 in credit card debt. Unfortunately, credit card debt is generally classified as bad debt—especially when credit cards are used to pay for luxuries and other consumables that won’t improve your long-term finances.
This is because, like payday loans, credit card use can land you in a spiral of debt if you max them out or only make minimum monthly payments. And, as the interest builds up, it becomes more and more difficult to stay on top of those minimum payments. What’s worse, many people misuse credit cards in a way that can damage their credit profile, by missing payments or carrying a balance month-to-month.
However, in some—albeit limited—circumstances, credit cards can still be good debt. For example, using a 0% APR credit card to consolidate and pay down other debts can be a great way to save money on interest while simplifying payments and paying down balances. Likewise, if you’re paying your monthly balances off on-time and generating significant cash back or rewards, credit cards can put money in the bank.
The Gray Area
When evaluating what constitutes bad debt, remember that there is a gray area. The true cost—and value—of debt is likely different from person to person. Here are a few types of debt that may be good or bad, depending on the circumstances:
Using a new loan to consolidate your other debts can be a great way to simplify payments, reduce your interest rate, and lower your monthly payments. However, if you don’t also change your approach to budgeting and money management, you may find yourself struggling to make payments.
Borrowing to invest.
Some people think that borrowing money at a low interest rate and investing it for a higher rate of return makes it good debt. And this can be true for experienced investors who are prepared to closely monitor their portfolio and accounts. However, if you don’t have experience with this type of borrowing, steer clear to protect your long-term financial health.
Borrowing against your 401(k).
Borrowing against your 401(k) can make a lot of sense under certain circumstances. After all, there’s no lender so you don’t have the risk of default. However, if you separate from employment, you have to pay the money back in full. Otherwise, it will be treated as a taxable distribution and you could be exposed to additional fees and penalties.
Debt often carries a negative connotation but some things qualify as good debt because they can actually help you grow financially. Buying a home, getting a degree, or investing in business or real estate can all be effective ways to expand your assets and grow your earning potential. To make the most of your cash, however, avoid bad debts—like credit cards and car loans—that can sap your financial resources without improving your bottom line.