Good Debt vs. Bad Debt

Being burdened with debt is overwhelming and can even seem crippling. However, some of that debt might actually be beneficial to your finances. In spite of the stigma it carries in the minds of consumers, debt can generally be separated into the two categories of “good” and “bad.” It’s important to know the differences between good versus bad debt for better understanding.

What is Good Debt?

Good debt is the type of debt that you accrue when it is used to finance something that will gradually increase in value over time. One of the best examples of good debt is a mortgage. It allows you to purchase a home, and after several years in the future, after you have paid off your mortgage, your home might be worth a considerable amount more than its original purchase price. Student loans and business loans are also good examples of good debt. The former allows you to get a degree, which can help you to get a better job and a better salary. The latter allows you to improve and expand your business, which can help to increase profits.

In general, good debt is an investment for the future. It means you are spending money now while expecting to get it back in the future. Additionally, your payments toward good debt are spread out over many months or even years, which means you can immediately finance the debts instead of waiting many years to save and spend all at once. Good debt also tends to have a lower interest rate that is usually in the single digits.

What is Bad Debt?

Bad debt is essentially the opposite of good as it does not do anything to give you benefits back on an investment. For example, a car loan to purchase a new car is considered bad debt because the moment you drive the vehicle, it loses value. At the same time, you are required to continue paying off the car loan, plus interest rates. Another, even more accurate example of bad debt is credit card debt. If you are constantly using your credit card or multiple cards to make purchases, not only does it adversely affect your credit score, but you will also have high interest rates and no long-term investment on things you purchase.

Among the worst types of bad debt are payday loans. These are the types of loans that require the borrower to write a personal check to a lender for a specific amount they wish to borrow. However, they also include a sizable fee. Payday loans are bad investments because they must be paid back immediately after the borrower gets their next paycheck, hence their name. In some cases, the interest rates can be as high as 300 percent. If the loan is not paid back by the next payday, the borrower has to deal with an additional processing fee for rolling it over.

How to Be Wise About Debt

The wisest borrowers always try to make the most out of their good debt and minimize their bad debt. Generally, anything that comes with high interest rates and large fees is dangerous, especially when they can easily put you behind your payments. Using a credit card responsibly means making timely payments to pay back your bills, which keeps your interest level low and helps you to have a good credit score. At all costs, you should avoid buying things you can’t afford to pay off and should always stay within 30 percent of your total credit limit. It will help you to avoid the trap of debt in the long run.

The best way to ensure that you end up with more good debt instead of bad is to ask yourself if you really need a certain item you’re considering buying. If you can conceivably make a profit off of it, it might be worth your while. However, if you can’t foresee making money from the items, you might want to avoid purchasing it or at least wait until you are able to pay cash for it.

Finally, the best way to ensure that you don’t overuse your good debt is to limit yourself to a 43 percent debt to income ratio. It is a worthwhile investment and a way to be wise about your debt as it can keep your monthly payments low.