Good Debt vs. Bad Debt

Debt has become as American as baseball and apple pie. And though most people struggle under the burden of their debt, not all debt is bad. In fact, there is some good debt.

What is Good Debt?

Good debt is money you’ve borrowed that will improve your financial position. Good debt is used to purchase things that will appreciate in value or that will help you make money. Some examples of good debt include student loans, mortgage loans, and business loans.

Student loans are used to finance an education that increases your earning potential. There's also a tax advantage to paying interest on qualified student loans. Mortgage loans pay for houses that hopefully increase in value. Mortgages also have tax advantages. Finally, business loans finance business endeavors that help you earn more money.

What is Bad Debt?

Bad debt, on the other hand, does nothing to improve your financial position and is most often used to purchase items that depreciate in value. Credit card debt is almost always bad debt not only because of the nature of the items that are purchased with credit cards but also because of the high interest rates that credit cards have.

Even though you might consider a car something that could help you earn more money, an auto loan is most often considered bad debt because cars (typically) depreciate in value.

When Good Debt Goes Bad

Good debt can easily turn into bad debt, especially you take on too much of it. For example, if the cost of your tuition and expenses is $7,000 and you take out student loans totaling $15,000, that extra $8,000 has just become bad debt. The same thing goes for purchasing a home that costs more than you can afford to repay. Keep good debt good by borrowing only what is necessary and what you can afford to pay.

Another thing that can turn good debt into bad debt is using it to pay off bad debt. That can happen, for example, when you use your mortgage to pay off extra credit card debt.

Does Good vs. Bad Matter?

Just because some debt can be considered "good" doesn't mean it's any easier to pay than "bad" debt. Good debt often has a lower interest rate which lowers the cost of borrowing, but it's also often accumulated in higher amounts than bad debt. Good or bad debt, at the end of the day, you still owe money and more of your paycheck goes toward paying others.

When it comes to paying off your debt, try to get rid of bad, high interest rate debt first and save the good debt for last.

Good and Bad Debt on Your Credit Report

Your credit report does not distinguish between good and bad debt. For instance, both student loans and credit card accounts will be scored like all other accounts in your credit history – that is, based on how much you owe and if you make your payments on time.

That's why it's all the more important not to take on too much debt, either bad or good. If you should default on a large amount of debt, it will most likely end up in a collections account, which has a disastrous effect on your credit score.

If you're a student, don't take out more loans than you need just because you qualify for them. And homeowners should decide for themselves what they can afford in a monthly mortgage payment, not what the banks say they can. Credit card balances should stay well below their limits, and ideally be paid off in full each month. These choices will lead to a higher credit score, and more importantly, less financial stress.