When it comes to terms that prompt anxiety and discomfort, “going into debt” is right up there with “tax audit” and “We need to talk.” But not all debt is the same—and knowing the difference between the good and the bad can keep your financial situation from getting ugly.
The difference between good debt and bad debt
In general, you can evaluate whether a debt is good or bad by considering the relationship between the money you’re borrowing and the time it takes to pay it off. Time is a major factor, since you’re often paying some amount in interest.
For example, a mortgage is usually considered good debt because the property will grow in value, and you’ll get to live there while it does. So, you get value from that debt instead of saving up every penny for a house—which, if you did, might mean not having your own home for a big chunk of your life.
Similarly, another example of good debt might be student loans. Especially with federal student loans, you pay less in interest than you would for a bank loan, and the subsequent degree is often an investment in your future income.
In contrast, bad debt would be using your “future money” for something that loses value. The biggest example is credit card debt, if the items charged don’t contribute in any way toward building financial clout. Another example might be taking out a home equity loan but not using the funds to build value in your home. Instead of remodeling or adding solar panels, for instance, the money’s spent on a lavish vacation. Long after your dream trip is done, you’ll still be paying on that loan, plus interest, without having invested in your future.
Take debt case by case
Even with mortgages and student loans, any debt can be bad debt. If you borrow more for a house than you’re able to repay comfortably, you might face foreclosure. Or, if your student loan amount is much greater than your post-college income, the advantages can dissipate quickly.
But the good news is that any debt can also be good debt. That credit card balance? If it’s made up of essentials for getting you a new, higher-paying job or making improvements to your home that raise your home equity level, then it’s beneficial—as long as you’re paying a low, fixed interest rate.
Even a car loan, which is often considered bad debt because vehicles depreciate so quickly, can tilt into the “good” category. It can happen if the interest rate is very low, for example, and that car is crucial for getting you to a swanky new job that allows you to pay off the loan quickly.
Best tactics to stay safe
To keep from accruing bad debt, consider the outcome whenever you borrow money, even if it’s swiping your credit card for some retail therapy.
It all comes down to how you use the debt. If you’re dealing with high, variable interest rates, no tax advantages, and a long repayment period, that type of debt won’t serve you well. And the deeper you get into that bad-debt hole, the more of a hit your credit score might take.
Using the right approach, borrowing money can help you achieve your goals and dreams, making debt into a smart tool for enhancing your credit and investing in your future. But like any tool, it needs to be used wisely. Limiting the amount that you borrow and focusing mainly on getting value in return for that debt, can keep you on a good track when it comes to financial management.
