The Difference Between Good Debt and Bad Debt

There is Good Debt and Bad Debt, Learn More About Both Here

One of the more important financial concepts is that of good debt and bad debt. Debt itself is any money that you borrow and need to pay back later. This could be in the form of a loan that you pay back in installments, or it could be a revolving line of credit where you're only required to make a minimum payment every month (although it's always smarter to pay more than the minimum).
So, how can you distinguish between whether debt is good or bad? Here's a guide to how they differ.

What Is Good Debt?

Good debt is when you borrow money to purchase something, and whatever you purchase will build more value than what you pay in interest. Some of the most common types of good debt are:

  • Mortgages
  • Student loans

The reason a mortgage would be considered good debt is because home prices tend to steadily increase and mortgage interest rates are often very low. Let's say you put down a $60,000 down payment and borrow $240,000 over a 30-year term to buy a $300,000 home. Your mortgage has a fixed interest rate of 4 percent. You'll end up paying $412,486.82 total for the loan with interest, plus your original $60,000 down payment.

If the home is worth $550,000 after 30 years, you've come out over $70,000 ahead.

Student loans are considered good debt for a different reason. You're not using them to buy something that will increase in value. Instead, you're investing in yourself and improving your earning potential. College degrees can add hundreds of thousands of dollars to your lifetime earning potential, which is why people consider them a good debt.

What Is Bad Debt?

Bad debt is when you borrow money to make a purchase that likely won't offer you greater value than what you pay in interest. Here's an example:

  1. You go to the mall and buy an $800 leather jacket using a credit card.
  2. You don't have the money to pay off the purchase in full, and instead you pay a portion of it every month for a year.
  3. Your credit card had a 20-percent annual percentage rate (APR), and you ended up paying $160 in interest, or $960 total for the $800 jacket.

This would be considered bad debt. Because you borrowed money, you ended up paying more for the product.

Classifying Debt as Good and Bad Is Subjective

It's important to note that the idea of good debt and bad debt is subjective. There are those in the financial industry who don't believe that there's such a thing as good debt. Everyone's definition of good debt and bad debt is a bit different.

Let's look at a vehicle loan as an example, which can be good debt or bad debt depending on who you ask. Some would argue that if you pay a vehicle loan that costs you $30,000 to buy a $25,000 car, which is only worth $15,000 by the time you finish paying that loan, then it was bad debt.

That's a valid argument. However, you could also say that the car is providing you with value every time you use it. How much do you value being able to drive anywhere you need? It will save you time by getting you to work more quickly, and that time could easily be worth a substantial amount over several years. Therefore, a vehicle loan could also be considered good debt.

Another example would involve title loans Texas. A title loan would usually be seen as bad debt. However, what if you're getting a new one to refinance title loan Texas with a higher interest rate? In that case, the new loan is saving you some money that you would pay in interest on the old one, making it a good debt.

Consider the Value You're Getting from the Debt

It's good to avoid debt whenever you can, and that's especially true with high-interest debt. But there are also situations where taking on debt can work in your favor. Maybe you have an opportunity to buy a home that's set to increase in value, or perhaps you can borrow a business loan to expand your business and boost profits. Consider the potential benefits and risks of any debt, and decide for yourself whether it's good or bad.