Good debt vs. bad debt

Is all debt bad? The answer isn’t that simple. You might be surprised to learn that not all debt is created equal. Some are bad debts for a reason, while others are more supportive types that help you achieve your goals in life. On this page, we compare good vs. bad debts, looking at examples of each and how you can avoid the bad kinds.

What is considered good debt depends on how it’s used. But generally speaking, any time you borrow money to improve your financial situation or work toward important financial goals, it’s often seen as good debt. The debt is typically easy to repay with favorable terms.

If you take out a loan with the goal of boosting your income potential or wealth, you are taking on good debt. You might describe it as borrowing with a purpose. When handled responsibly, this type of debt can also help build credit and improve your financial health.

Some definitions of good debt focus on loans with interest rates below 6%. But despite the label, no debt is entirely “good.” Even with a low rate, debt still needs to be managed responsibly, as taking on too much can put a strain on your finances.

To understand the differences more clearly, it can help to look at some examples of good debt:

• Student loans: Often seen as a worthwhile investment, student loans can help you obtain an education that leads to higher earning potential. By financing your studies, you’re investing in your skills and future career prospects. They may come with lower interest rates compared to other loans, meaning you may be more likely to be able to pay them back, depending on the size of the loan and the potential value of the degree it’s financing.
• Mortgages: Buying a home, whether an apartment or house, may be considered a good investment, depending on the exact circumstance. Homes have the possibility of appreciating in value over time compared to the sunk cost of renting, and mortgage rates are usually on the lower side compared to some types of loans, averaging 6.1%¹ as of September 2024. This can save you a significant amount of money over the life of the loan.
• Business loans: If you’re thinking about starting or expanding a business, a loan can be a solid way to generate income. But remember, the potential of the business plays a big role — if it doesn’t work out, that debt could easily become a burden, potentially turning into bad debt that you struggle to repay, leading to potential fiscal and legal penalties.

It might seem counterintuitive, but good debt can actually boost your financial health over time. When used sensibly, it can give you a head start and help you invest in opportunities that boost your chances of long-term success. In fact, borrowing responsibly — and keeping your debt at a manageable level — is one of the four key pillars of financial wellness.

When people hear the word “debt,” bad debt is often the first thing that comes to mind. But what is bad debt, exactly? Merriam-Webster gives a definition of bad debt as “loans that will not be repaid.” It can also include any borrowed money that’s unlikely to be paid back.

Bad debt often comes into play in business settings. When a business extends credit to its customers, there’s always a risk that some won’t be able to pay their bills. This can happen for various reasons — customers might miss payments, face unexpected financial challenges, or even declare bankruptcy. Bad debt is essentially those outstanding balances that a company considers uncollectible.

Having seen the meaning of bad debt, a few types might immediately spring to mind. In general terms, any debt with higher-than-average interest rates can fall into the bad debt category. This is especially true if there’s a strong chance the borrower might struggle to repay it. Sometimes, the lenders themselves engage in questionable practices, targeting vulnerable clients or charging exorbitant interest rates that even financially stable individuals would find hard to manage.

Here are some examples of bad debt:

• Credit card debt: This is perhaps the most common example. Credit cards often come with APRs in the 25-30% range, and if you’re not paying off your balance each month, that debt can snowball quickly.
• Personal loans: While personal loans can be convenient and sometimes even cheaper than credit cards — making them suitable for debt consolidation — they can become problematic if used for everyday expenses instead of emergencies.
• Payday loans: These short-term loans might seem like a quick fix for urgent cash needs, but their exorbitant interest rates can trap you in a cycle of debt that’s hard to escape. What feels like an easy solution can quickly turn into a financial nightmare.
• Loan shark deals: As the name suggests, these loans often come with astronomical interest rates and harsh repayment terms. Dealing with loan sharks is risky and can leave you with serious financial issues.
• Store card debt: Department store credit cards can offer tempting discounts, but carrying a balance can result in high interest charges that pile up before you know it.

Looking at good debt vs. bad debt, it’s clear that good debt is usually used for positive, value-generating purposes. In contrast, bad debt is sometimes entered into as a last resort, taken out in desperation to cover existing debt or expenses when the interest payments have become intolerable.

Some debts land in a bit of a gray area, and a car loan is a prime example. A reliable vehicle can be essential for work, but it might not be a sensible investment if it needs frequent repairs. Also, while new car loans typically have lower interest rates (ranging from 1.5% to 2.5%), a car’s value depreciates rapidly once it leaves the lot.

Medical loans also straddle the line; they’re justifiable for necessary healthcare, but private medical loans, in particular, can quickly spiral into unmanageable debt. Similarly, student loans can be a double-edged sword. They’re beneficial if they improve earning potential, but borrowing for degrees with little financial return can leave you struggling to repay.

Ultimately, the distinction between good debt vs. bad debt isn’t always clear-cut. What is considered “good debt” to one person may be seen as a financial burden by another.

If you carry too much bad debt, your credit score may suffer. Credit scores range from 300 to 850, with higher scores being better. About 30% of your score is based on how much debt you owe.

Making payments on time is the biggest factor in boosting your credit score. Even just one late payment can hurt your score. If you’re struggling to make minimum payments, it likely means your debt-to-income ratio is high. This not only affects your credit score but also limits how much money lenders are willing to give you.

If your bad debt results in an account going to collections, a foreclosure, or bankruptcy, you may experience an even bigger and longer-lasting impact on your credit score.

Find out more about what makes a good credit score.

To help you steer clear of bad debt and manage it effectively if you already have some, here are three strategies to consider:

You never know what’s round the corner, so it can help to have an emergency fund for those unexpected costs. Experts suggest saving three to six months’ worth of living expenses. That way, any unpleasant surprises - like a flat tire or surprise medical bill — won’t force you to rely on credit cards. You might consider a savings account that’s easy to access and earns interest, like a money market deposit account or high-yield savings account.

Start by tracking your income and expenses, then create a budget that reflects your priorities. For example, you might allocate funds for groceries, utilities, entertainment, and, of course, your emergency fund.

Sticking to your budget can help you keep your spending under control and avoid unnecessary debt. And if you do have existing debt, you might consider following a debt payoff plan to help you get ahead.

One of the simplest habits to get into is paying your bills on time. You might set reminders for due dates or automate payments to avoid late fees. And if you have credit cards, paying off the full balance each month helps prevent interest charges from building up, and also demonstrates to lenders that you’re a responsible borrower. Over time, this can lead to a higher credit score.

The following table gives an overview of the main differences between good debt and bad debt.

At Raisin, you can access a variety of products, including high-yield savings accounts, money market deposit accounts, high-yield CDs, and no-penalty CDs. These options help you grow your savings and create a financial cushion that can help prevent you from resorting to bad debt. Simply register for a free Raisin login, open an account, deposit your money, and watch your savings grow!

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

Sources

¹ https://fortune.com/recommends/mortgages/current-mortgage-rates-09-25-2024/