If you’re like most people, you’ve got at least some debt—a student loan, a car loan, a credit card or two—and you may have heard the terms “good debt” and “bad debt.” But what makes one debt “good” and another debt “bad”?
Having some debt is simply a fact of life at some point for a lot of folks. Whatever your relationship to debt right now—racking it up, trying to pay it off, or a pay-cash-or-do-without diehard—knowing the basics of what makes for good debt vs. bad debt can help you make more empowered choices about money and build your financial confidence.
A note on “good” vs. “bad”
Before we dive in, let’s talk about the terms “good” and “bad.” We use those words here because that’s how financial experts talk, and learning to sling the lingo can help you navigate the financial world more easily. But your debt doesn’t make you good or bad—or characterize your financial circumstances on some moral scale. No matter what your financial situation is, knowing how the debt game is played can help you make the most of your financial world.
What is good debt vs. bad debt?
In the broadest sense, good debt is something that improves your financial situation in the long run (helping you generate income or increase your net worth), while bad debt puts you in worse financial shape when all is said and done.
So how do you make that calculation?
Most experts agree on a simple formula: the less it costs to borrow money + the higher the long-term value of what you buy = the better the debt.
Cost of debt
When you borrow money, you have to pay back more than what you borrowed, in the form of interest and fees. The more you have to pay—over and above the initial amount you borrow—the more likely the debt will wind up in the “bad” category.
For example: taking out a personal loan with a low fixed interest rate—that skews good. On the other hand, you’re wading into dangerous territory with a credit card that offers 0% interest for twelve months…and then after the introductory period, your interest rate goes through the roof!
Borrowing money to buy something that will keep or increase its value is more likely to be good debt. Taking out credit for purchases that lose value fast: that’s probably bad debt.
So getting a mortgage to buy a house? You have a piece of property that’s likely to be worth as much or more than the sale price later on. That’s good debt! Putting morning coffee runs on your credit card and making the minimum payment every month? Your purchase is gone in a few sips—and you’re on the hook for paying it back plus interest. That’s a fast way to rack up bad debt.
Of course, figuring out how a particular debt decision will affect your unique circumstances is a bit more complicated. Let’s look at some good debt vs. bad debt examples to dig deeper into how borrowing money can affect your financial outlook.
The deets on good debt
So what kind of borrowing makes for good debt? Here are a few common examples of good debt:
- A home mortgage
- A home improvement loan
- Student loans
- Small business loans
The classic example of good debt is a home mortgage. Once you sign on the dotted line, you’ve got something valuable that you can sell later (ideally, for more than you paid). Plus, you can borrow against your house to get funds for improvements that will increase its value (i.e., a home improvement loan).
Student loans are also widely considered good debt, because you’re increasing your earning potential and opening up more possibilities for employment, often with a low fixed interest rate. Small business loans are similar—you’re creating opportunities to generate more wealth through your business, and interest rates are often on the low end of the scale.
Beware bad debt
Okay, then what is bad debt? Here are a few typical examples of bad debt:
- Credit cards that you don’t pay off every month
- Installment plans for consumer goods (like clothes or electronics)
- Some auto loans for brand-new cars
- Payday loans or title loans
The most common example of “bad” debt is using a credit card to buy everyday things (like food or entertainment) and carrying a balance on that card. Remember the “long-term value” factor: does the thing you buy keep or increase its value? The takeout was delicious, but it’s all gone in one sitting—and now you’re paying more than the original cost in interest (potentially a lot of interest) when you don’t pay off your card every month. The same often goes for installment plans that charge interest while you make payments over time.
But remember, if you make a purchase on your credit card and pay it off before it accrues interest, it’s not debt at all!
While it may be surprising, many experts also consider auto loans bad debt if you’re buying new. The main reason: most new cars lose about 20% of their value (according to NerdWallet) the minute you drive them off the lot! That depreciation eats into the long-term value you’re going for when taking on debt. Of course, not many of us can plunk down the full cost of a car when we need one. So to keep your auto loan out of bad-debt-territory, consider buying used (so you don’t eat the cost of depreciation), put down as large a down payment as you can, and shop for low interest rates.
Finally, payday loans and title loans (where you borrow against an upcoming paycheck or the value of your car), are universally considered bad debt—even predatory debt. Lenders may prey on people in serious financial trouble and extract sky-high interest rates and fees.
Can good debt go bad?
Even debt that’s “good” in theory can be a problem in practice. Take those classically “good” mortgages. They’re not all created equal—sneaky variable interest rates and balloon payments can really rock your financial world. Similarly, student loans can increase your earning power, but keeping up with payments can be tough if your debt is particularly large (and not even bankruptcy will cut you loose from those babies!).
And of course, if you’re laid off and can’t make payments, late fees and mounting interest will turn good debt into bad quickly. It’s smart to be confident you can afford to pay back what you borrow—no matter how good the debt seems.
Know your debt-to-income ratio
There’s always risk when you take on debt—even very good debt!—so you’ll want to make sure you can afford payments before you borrow. That’s where your debt-to-income ratio (DTI) comes in.
Your DTI is simply the percentage of your income you have to spend on all your debt payments each month. Lenders look at this number to decide whether you can afford to pay back a loan—and it’s smart for you to make the same assessment yourself. Generally, a DTI below 20% is considered “excellent,” while one ofer 40% is considered a sign of financial stress. (That info comes from NerdWallet—read more and use their DTI calculator.)
At this point you might be wondering if it’s even possible to avoid bad debt. But remember: “good” and “bad” aren’t value judgements. Everyone has different resources and circumstances. If you’re lucky enough to have a relative who will help you out in a pinch, maybe you can avoid running up your credit card. On the other hand, if you have a medical emergency, you may well end up with a big bill to pay off over time.
Life happens, and debt happens. What matters for your financial future is being thoughtful about taking on any new debt, and making a plan to deal with whatever debt you do have. Here are a few debt-busting tips that can get you started:
- If you have multiple credit cards with high interest rates, consider consolidating them with a fixed-rate personal loan
- If you’re able, start building an emergency fund so you can handle the unexpected without pulling out the plastic (here’s a guide to building your fund faster)
- Any time you take on debt—even for something small—make a plan for how you’ll pay it off and put those payments in your budget
- If the thing you want to buy can wait, consider saving up for it instead. (If you’re a Simple customer, you can put your savings in an Protected Goals Account and earn interest to reach that goal faster)
- If you’ve got both good and bad debt, focus your plan on paying off the debt that’s costing you the most first
Sometimes debt is unavoidable—that’s just a fact of life. And while there are some “good” kinds of debt—the types that put you in better financial shape over the long term—all debt comes with risk.
Of course, there a lots of reasons to take on debt, from making an investment in something that holds its value (like a condo) to scraping by when times are tough (like if you lose your job) to buying something that makes your life materially better (like equipment that allows you to get around better if you have a disability).
Debt (like all financial stuff) is morally neutral; what’s ultimately good debt for you depends on your personal values. At the end of the day, knowing the difference between good debt vs. bad debt can help you cut through the confusion and make choices that are right for you.
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