Knowing the difference between good debt vs. bad debt is key to building a strong financial future. Debt can be either a tool for growth or a financial pitfall. While not all types of debt are harmful, having the wrong type makes it difficult to build wealth.
Let’s take a look at what separates helpful debt from costly debt and see how to manage each one wisely so you can maintain sound financial health.
What is Debt?
Debt is borrowed money you agree to repay, usually with interest. While it can be necessary to go into debt when making big purchases or some types of investments, not all debt serves the same purpose.
The key to managing debt well is knowing the difference between “good debt” and “bad debt.” Understanding this distinction can help you build and protect your financial well-being.
What is Good Debt?
Good debt is money you borrow to support your future. It usually has lower interest rates and offers long-term benefits. Here are some examples of good debt:
- Mortgages: Buying a home often requires incurring significant debt, but it’s usually considered good debt. A mortgage allows you to build home equity over time and provides potential tax benefits, making it a valuable investment in your future.
- Student loans: Student loans are often good debt, as they may open doors to higher-paying careers in the future. For example, someone who becomes a lawyer might take on substantial student loans but has the potential for a rewarding career that makes the investment worthwhile.
- Business loans: Business loans may fund new ventures or help expand existing businesses, which can lead to increased income over time. Borrowing to build a business can be good debt if it fuels long-term financial growth.
What is Bad Debt?
Bad debt typically has high interest rates and doesn’t offer a return on your investment. Here are a few examples:
- Credit card debt: When not managed carefully, credit card debt becomes expensive due to its high interest. Borrowers use this type of debt to pay for items such as clothes or electronics, which lose value quickly. Along with high interest rates, this makes credit card debt financially risky.
- Payday loans: Payday loans cover short-term expenses. However, they come with high fees and interest rates that can result in the borrower falling more deeply into debt. Borrowers may quickly find themselves repaying far more than they initially borrowed.
- Auto loans: A car is essential for most people, but it depreciates quickly. An auto loan is considered bad debt because the car loses value over time, and high interest rates (particularly on used cars) may make repayment difficult.
The Middle Ground: Debt That Can Be Both Good and Bad
Some debt can go either way — good or bad — depending on how it’s managed.
- Auto loans: While cars depreciate, a low-interest loan for an affordable, reliable car can be reasonable. On the other hand, high-interest loans on luxury cars can be burdensome.
- Credit cards: When used strategically, credit cards may help you build your credit score. Many of these cards also offer rewards, such as cash back or travel points. However, carrying a balance and paying high interest can quickly turn this type of debt into a financial burden.
How to Turn Bad Debt into Good Debt
If you find yourself with bad debt, there are ways to transform it into manageable forms.
- Debt consolidation: Combining high-interest debt, such as credit card debt, into a single loan with a lower interest rate may simplify your finances and reduce the overall cost of your debt.
- Balance-transfer credit cards: Some cards offer a 0% introductory interest rate for balance transfers, which lets you pay down debt without accumulating additional interest.
How to Avoid Bad Debt
Smart financial habits and planning may help you stay clear of bad debt. Such habits include:
- Budgeting: Planning your spending helps ensure you’re living within your means, making it less likely that you’ll rely on credit cards or loans for essential purchases.
- Building an emergency fund: Setting aside funds for unexpected expenses reduces the need to borrow when life throws you a curveball.
- Using credit responsibly: It is typically best to use credit cards only for purchases you can pay off in full each month. That way, you avoid high interest charges.
Debt Can Be a Part of Your Financial Strategy
When used wisely, debt may be a valuable tool for reaching financial goals. The key is understanding and managing good debt, such as mortgages and student loans. These types of debt often contribute to wealth-building.
In contrast, high-interest debt — such as payday loans and revolving credit card balances — may become a financial burden over time.
Making informed choices, avoiding unnecessary borrowing and using good debt management practices can help you use debt to work on your behalf, not against you.
