Financial Leverage: What Is Good Debt vs Bad Debt? | U.S. Bank (2024)

For most Americans, debt is a common part of life; U.S. household debt reached $17.69 trillion in Q1 2024.¹ Although many people don’t like to take on debt, it’s not inherently bad. In fact, some forms of “good” debt can be used as leverage to help you take advantage of financial opportunities.

Let’s explore how to tell good debt from bad and how to leverage good debt to help you achieve your financial goals.

What is good debt?

Good debt is money you borrow for something that has the potential to increase in value or expand your potential income. For example, a mortgage may help you buy a home that can appreciate in value. Student loans may increase your future income by helping you get the job you’ve wanted.

In other words, good debt is often considered an investment you’re making for a future outcome.

“Good debt can help borrowers accomplish an objective, or help them avoid a bad outcome,” explains David Mook, senior vice president and chief private banking officer for U.S. Bank Private Wealth Management.

Good debt also is more likely to have a lower interest rate or annual percentage rate (APR) than bad debt such as credit card debt, meaning you’ll pay less in the long run to borrow it.

Examples of good debt

• Student loans. Student loans are probably the most common example of good debt, given the correlation between a college degree and a higher earning potential throughout your career.²
• Home mortgage. Most people can’t pay cash for a house. However, even if you could, there are benefits to having a mortgage. For one thing, there may be tax benefits, namely the mortgage interest deduction if you itemize your deductions. For another, you could invest that cash in other ways to help you save for retirement or other major financial goals. Also, if you know you’ll be able to make your monthly payment consistently, you’ll improve your credit score.
• Small business loans. Borrowing to fund a business can be a strategic move that helps support future wealth. By using debt to invest in your business’s growth, you may be able to increase future earnings.

What is bad debt?

Whereas good debt can be seen as something that contributes to greater wealth over time, bad debt is borrowing for something that you consume quickly or something that depreciates in value.

“I would equate bad debt with taking on too much risk without the ability to repay it,” says Mook. He adds that “borrowing to support ongoing living expenses is not a good use of debt.”

Typically, bad debt doesn’t help you make progress toward your financial goals. The best example is high-interest credit card debt, especially if you can’t pay off your balance each month.

Examples of bad debt

• Credit card debt. Credit card debt is probably the most common example of bad debt. The average card balance is almost $6,000 per person in the U.S.³ It’s often considered to be a form of bad debt because of its high interest rates, which can make it harder to pay off.
• Car loans. Car loans are another example of bad debt because they’re used to buy an asset that depreciates: your vehicle. To help avoid a high interest rate, make as large a down payment as you can.
• Payday loans. Payday loans are notorious for being predatory. These short-term cash advances—often seen as a lifeline in a financial crisis—can quickly turn into a debt trap due to their hidden fees and very high interest rates, which keep people stuck in a cycle of bad debt.

Good debt vs. bad debt: What’s the difference?

Whether a given type of debt is “good” or “bad” depends on several factors, including:

• The interest rate attached to the debt
• The amount of time it will take you to pay back the loan
• What you’re borrowing the money for
• Your personal tolerance for debt, or the amount of debt you can comfortably manage

Overall, debt is considered good if it’s used properly and can help you achieve your financial goals and build long-term wealth. Bad debt, on the other hand, is debt that can harm your credit and deplete your finances if you’re not careful.

Of course, with any type of debt, careful consideration is essential to ensure your debt is manageable and you’re not putting your personal finances at risk.

How to use good debt as financial leverage to achieve your financial goals

Understanding the difference between good debt and bad debt, let’s explore how you can use good debt to make the most of your financial future. It hinges on a concept called financial leverage.

What is financial leverage?

Financial leverage is when you use borrowed money to potentially amplify returns on an investment. “This type of debt can be a part of your personal financial strategy if you employ it in moderation and use the right tactics,” Mook says.

Say you’re investing $100 with an expected 10% rate of return. If you invested $100 of your own money, you would earn $10. But if you invested only $50 of your own money and borrowed the remaining $50, the same $10 would represent a 20% gross return on your invested capital of $50. If the interest on the loan is less than 10%, your net rate of return will be higher using leverage. In this example, says Mook, “you leveraged your return.”

Another example of financial leverage is when you use a loan to diversify your investment portfolio, such as if you hold a concentrated stock position in a single company. You could borrow against that concentrated position to buy stocks in other companies, resulting in a more balanced long-term investment strategy.

“You don’t want to be overleveraged in any way, shape or form, but leverage in moderation can be a really powerful tool,” says Mook.

Examples of financial leverage

Here are three types of financial leverage that could help you reach your financial goals: liquid asset secured financing, home debt and estate planning debt.

1. Liquid asset secured financing

A liquid asset secured line of credit is like a home equity line of credit (HELOC), except it’s secured by your investment portfolio instead of your home. This allows you to access liquidity without the need to sell assets and therefore potentially incur capital gains taxes from the sale of the assets.

Liquid asset secured financing may be a good option for you if you need to generate cash flow quickly. It also offers the benefit of lower-interest rates, as it’s a lower-risk option.

Uses for liquid asset secured financing include:

• Funding special purchases
• Paying a tax bill
• Refinancing higher interest rate debt

2. Home debt

A house is an asset on its own, but you can also leverage its equity. You can use money from either a second mortgage or a HELOC to buy a second home, renovate an existing home or purchase a commercial property. Doing so can generate income while also diversifying your portfolio.

Leveraging your home is a higher-risk way to borrow, but for those with a higher risk tolerance, the advantages of real estate investments are clear:

• If you believe the real estate will appreciate, you can access liquidity without selling the property and missing out on potential future gains in value.
• You may be able to rent out a second property, generating additional income.
• Small business owners may be able to use money from a second mortgage to fund their business at a lower rate than what’s available to the business entity.

3. Estate planning debt

Contrary to popular belief, debt can facilitate wealth transfer. Two estate planning strategies could help: life insurance policies and grantor retained annuity trusts (GRATs).

Life insurance policies

Add this as another reason to have life insurance: You can use your policy to help pay for estate taxes after your death. Leveraging your life insurance policy allows the estate to distribute assets at a pace that maximizes the estate’s value.

Mook notes that insurance can be expensive. “If you don’t want to write a large check every year,” he says, “you can finance that premium and use the cash value of the policy or other assets as collateral for the loan.”

Grantor retained annuity trust (GRAT)

A GRAT is an irrevocable trust set up for a short time (usually two to five years) that helps transfer assets to beneficiaries in a tax-efficient way. You place assets into the trust and the trust pays you a fixed annuity each year, usually a set percentage of the original amount of assets.

Over the life of the GRAT, the assets will inevitably rise and fall in value. Bank financing could help protect your gains and shield you from losses by allowing you to substitute a stable asset for a high-growth one.

For example, substituting cash for stock secures any gains in the stock value to date. If you don’t have the cash to make that substitution, a bank can lend it to you.

When the terms for your GRAT are up, the remaining assets, including any appreciation on the assets, transfer to your beneficiaries tax-free. However, if you’re no longer alive when the GRAT terminates, the assets become part of the estate and subject to estate tax.

Helping your good debt work for you

By understanding the types of debt you have and how they’re either helping or hurting your finances, you can gain more peace of mind about the future. And in general, financial leverage can be a smart strategy if you know which tactics will work best for your situation.

“We want to give our clients flexibility,” Mook says. “By helping them use leverage, we can make sure they’re able to take advantage of financial opportunities when they become available.”

If you have questions about which debt strategies are available to you, consult with a financial professional. They can help you come up with a personalized plan to ensure you’re using debt in a way that supports your overall financial goals.