There’s a stigma attached to the word “debt.” When you hear it, you may equate it to spending above your means—using one’s finances irresponsibly, even.
That’s certainly one aspect of debt. But did you know that not all debt is necessarily bad? Here’s how to tell the difference between “good debt” and “bad debt.”
What is good debt?
Good debt is when you borrow money to finance something that can increase your net worth or your ability to generate income. For example, a mortgage is considered good debt, as paying down your balance results in home equity. In other words, it’s an investment as opposed to an impulse purchase.
Some examples of good debt can include:
- Home renovations (can increase your equity)
- Student loans (furthers your career and therefore your earning potential)
- Business loans (potential to increase your income)
- A necessary auto loan (if it’s vital to your ability to make money)
In short, if the cost of the debt is outweighed by the return you’ll get, it can be considered a good debt. Also note, good debt will tend to have low interest rates. Some may even have interest payments that are tax deductible.
What is bad debt?
Bad debt is when you borrow money for things that don’t add to your wealth or increase your income. When borrowing for things like a fancy vacation or a wedding above your budget, you’re likely to pay comparatively high interest rates, as you’ll often be using either a personal loan or a credit card. For example, at the time of writing, the current rate for a 30-year fixed-rate mortgage is 6.292%, but the average credit card APR is 21%.
Some examples of bad debt include:
- Credit card debt incurring interest charges (high APRs make it difficult to dig yourself out of a hole, especially if you’re only making the minimum monthly payment)
- Payday loans (predatory rates and fees)
- An unnecessary auto loan (purchasing a car above your budget)
- Cash advances (APRs will typically exceeds standard credit card rates and offer no grace period)
All to say, your wealth is eroded by bad debt. Of course, there’s nothing wrong with discretionary spending—as long as you can make such purchases without going into debt.
Can good debt turn into bad debt?
Another key factor when determining good and bad debt is whether you can afford the payments. Even good debt can be detrimental to your finances, depending on your situation. You should never take on more debt that you can reasonably afford.
As an example, while home loans sit firmly in the “good debt” bucket, having three such loans at the same time may be unsustainable for your budget. This can lead to defaulting on one or more loans, which can result in a wrecked credit score and the lender taking your property.
How to pay off bad debt
Taking inventory of where each penny is going is critical to managing debt. You’ve got to have a clear understanding as to how much money is left over after paying all necessary expenses. Then you’ll know the amount of funds you can afford to put toward your debts.
Once you know how much you can afford to throw toward your bad debt, you can formulate a plan.
Debt snowball method
A common process for repaying bad debt is the snowball method—paying off the smallest balances first and therefore eliminating monthly minimum payments the fastest. The fewer minimum payments you have, the more monthly funds that can be used to repay the next lowest balance.
The snowball method can also be good for the mind; seeing your outstanding accounts disappear can boost your morale as you see your progress.
Debt avalanche method
Instead of focusing all your energy on your smallest balance, the debt avalanche method prioritizes debts with the highest interest rates. This is a common-sense strategy that works to minimize the amount you pay in fees. Depending on the accounts with the highest APR, it may take longer to eliminate your number of monthly minimum payments—but it can potentially save you more money in the long run.
Debt consolidation
A debt consolidation loan gives you an upfront lump sum of cash that you’ll use to zero out multiple other loans (credit cards, personal loans, payday loans, etc.).
Debt consolidation helps to expedite your journey out of debt in two major ways. It effectively combines the effects of both the snowball and avalanche methods into one:
- It lowers the number of minimum payments you’ll make each month.
- It (likely) reduces your interest rate, as credit card APRs are often far above those attached to personal loans.
Both of these perks generally allow you to throw more money toward the principal amount of what you owe.
Should you pay off good debt early?
Paying down bad debt should be the top priority. But what about good debt? Does it benefit you to throw extra funds toward a mortgage instead of saving or investing?
To decide, ask yourself these two important questions.
Do you have a meaningful amount of savings?
Having substantial savings is crucial to a healthy financial picture. This gives you the ability to weather emergencies and unforeseen expenses like medical bills, car repairs, or a job loss. When deciding whether you should pay off debt or save first, consider that experts recommend keeping between three and six months worth of living expenses in your savings account.
If you’ve got little or no emergency fund, prioritize your savings. It can be worth paying a little more in interest to guarantee that you can stay current on your payments—particularly for secured loans like a mortgage, or sometimes an auto loan, where the ramifications for delinquency can involve repossession of your property.
What is your debt’s interest rate?
Your debt’s interest rate is a major factor when considering how to best use your disposable earnings. If you’re not hemorrhaging money toward a high APR, your funds may be better deployed elsewhere.
Financial advisors oftentimes abide by “the rule of 6%.” In short, if your interest rate is 6% or greater, you should probably focus on paying down that balance as quickly as possible. If it’s below 6%, you may do better by investing your money.
For example, the historical performance of the S&P 500 shows the average stock market return to be around 10% each year. That should outpace the money you’re losing in interest each year if your debts have low interest rates.
The takeaway
A simple way to quickly categorize your debt is to analyze whether it’s more financially beneficial to save your money until you can afford the thing or borrow now and pay interest.
If you want a shiny new electronic device for recreational purposes, you can bet it’s a better idea to wait until you can pay cash for it; but if it’s an investment for the future, like a business loan or a home loan, the interest you pay could well be offset by the return you get.
Frequently asked questions
How do I know if I have too much debt?
Your debt-to-income ratio (DTI) is a great indicator to help you gauge whether you’ve got too much debt. If more than 35% of your total monthly income goes toward repaying debts (credit card balances, mortgage, personal loans, etc.), you’ve got more debt than is ideal. If your DTI is above 50%, it needs to be addressed immediately.
Can good debt turn into bad debt?
Yes, good debt can turn into bad debt if you can’t afford it. Any debt, even if it has the potential to result in improved net worth, is bad debt if you’re unable to make the monthly payments. Delinquent loans will ravage your credit score, and property related to any secured loans may be repossessed.
Is credit card debt always bad debt?
Credit card debt is generally considered to always be bad debt. That said, you may consider opening a balance transfer credit card to take advantage of a 0% intro APR offer and relocating other high-interest debt to the card. During the interest-free window, you may consider this “good” debt in the sense that it’s a shelter from crippling interest. Just make sure you can pay it off before the standard APR kicks back in.
Are car loans good debt or bad debt?
Car loans can be either good debt or bad debt. Remember, good debt is considered something that contributes to your net worth or is necessary to earn money. If you need a car to get to work, a car loan can be good debt. If you simply want a fancy car that you can’t pay cash for, your car loan is considered bad debt.
Should you pay off bad debt before good debt?
Yes, you should pay off bad debt before good debt. Bad debt often has higher interest rates with no return on building your equity or other positive factors.
