Bad Debt vs Good Debt: A Useful Guide

Is all debt bad? Andrii Yalanskyi/Shutterstock

In previous articles, I have used the terms “good debt” and “bad debt,” and the latter term undoubtedly has seemed like somewhat of an oxymoron to some. Getting into debt is considered a cardinal sin to many who give advice within the personal finance world. But, while some high-interest debt, such as credit cards, can be bad and lock you into a cycle of owing money for many years, not all debt is necessarily “bad.”

Taking on debt can be practical if used as a tool and as something within your financial capability. Taking on debt can be daunting if done under the wrong circumstances, but if you look at it as an advantage and use it pragmatically, it can be a powerful tool.

“Bad” Debt Versus “Good” Debt

To better understand how to leverage debt, it is essential first to understand the differences between good and bad debt.

“Good” debt typically refers to debt whose purpose can help increase or build wealth over time. Examples of good debt may be mortgages, student loans, or business loans. “Bad” debt often refers to a type of debt whose purpose does little in terms of building wealth or income. Examples of bad debt are credit card debt and other types of consumer debt.

This is a general rule of thumb.  The classification of what is good debt and bad debt is not nearly as black and white as these definitions. The actual disparities are much more nuanced, and an individual’s overall financial portfolio should be considered. For example, student loans taken out can certainly be used to open doors that lead to higher-paying careers. However, they can also come at a steep cost which puts college graduates tens of thousands of dollars in debt right out of college, with high monthly payments.

Leveraging good debt successfully is contingent upon a multitude of factors.

Gravitate Towards Good Debt

Many of us have been taught to avoid debt, and many people are wary. However, prudently taking on debt can help you achieve financial goals and build your net worth. The ability to borrow money can be a strong tool if done wisely. Good debts are worth more than they cost.

Stick to taking out debt to fund the purchase of something that will go up in value. Good debt improves your life, while bad debt will keep you from reaching any financial goals. Both mortgages and student loans are often cited as good debt. Since your home’s value can appreciate and a college degree can lead to higher-paying jobs, both are often considered good debt. However, borrowing more than you can afford or not understanding the mortgage terms can result in a risky endeavor. Likewise, if your major of choice does not result in an adequately paying job to pay down the debt, college debt can certainly be a cause for concern.

Investing in small business loans is often considered good debt, assuming the business can become successful and turn a profit. Small business loans are similar to student loans in that the purpose is to help you earn more money in the future.

Of course, there are still inherent risks with these loans. And the ultimate success, or failure, of the loan depends on the success of the underlying project the debt is funding, whether it is a small business or a career (post-graduation). However, “good debt” can certainly be a great option if your debt burden is manageable.

Avoid Bad Debt Entirely if Possible

Bad debt is debt that costs more than it’s worth, and that can have detrimental consequences, such as bankruptcy. Simply put, bad debt is generally any debt that can never be repaid by the activity the debt originally funded. Bad debt often does not provide a good return for its investment and has a negative impact on credit scores.

Credit card debt is perhaps the biggest source of bad debt for people. Credit cards charge high-interest rates, and their fees can continue to accumulate to unmanageable levels. If you pay down your balance every month, credit cards can be good tools to build credit, manage cash flow and earn reward points and bonuses.

Payday loans target people who do not have good credit and otherwise would not qualify for credit cards or other types of loans. These people often seek short-term financial help via payday loans or check-cashing stores. However, these services often come with exorbitant interest rates and fees that leave them in a worse state. These services are often used by individuals in dire financial straits. Avoid them at all costs, as the cost is far greater than the short-term benefit.

In short, be extremely wary of high-interest loans or loans with unusually long terms. These predatory loans are targeted at individuals who have no other legitimate alternatives. They come with astronomical interest rates, confusing payoff terms, and a plethora of charges relating to penalties. Payday loans can fall under the umbrella of these predatory loans, although other loans, such as tribal loans and even certain auto loans, can be predatory as well (some auto loans have terms exceeding 84 months). Though the lower monthly payments may entice some, the result of the extended term may be that you pay vastly more than the car or initial amount is worth.

Decide if the Debt Is Worth It

Debt is an essential aspect of modern life. It can certainly have dire financial consequences if structured poorly or dangerously. However, if structured strategically, calculated debt can set you up for a healthier financial future.

The first question to ask yourself is how the purchase benefits you. Think in the long-term about this rather than the short-term. Does taking on this debt provide a tangible, lasting benefit, that ultimately outweighs the cost of the debt, or is it merely something that satisfies an impulse or short-term desire you cannot afford?

Credit cards are often the biggest source of bad debt. If structured accordingly, these credit cards can be a great way to build credit. However, people often use credit cards for emergencies and find themselves in a hole that is difficult to get out of. Having an emergency fund available for these situations is a great way to avoid excess purchases on your credit card, thus preventing you from taking on excess bad debt.

The Bottom Line

Paying your bills on time and maintaining a low debt ratio (how much you owe versus the total amount of credit available to you) is imperative to healthy financial status. If you do this, you will be given more favorable terms, should you decide to take on any new debt. Avoid frivolous purchases and ensure that any debt you take on is conducive to increasing your net worth: this is of paramount importance when leveraging any type of debt.

The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.