Good debt vs. bad debt
Some types of debt are considered “better” than others and the distinction of whether they’re deemed “good” usually centers on benefits like these:
- Builds or improves your credit.
- Adds stability to your financial situation.
- Grows in value and gives you the opportunity to build wealth.
- Offers potential tax breaks.
- Produces a return on your investment.
On the flip side, there are many forms of debt that people call “bad” debt. It’s generally the kind of debt that’s considered not as helpful generally include potential risks like these that may works against you:
- Higher interest rates and less favorable terms, which increases your cost of borrowing.
- Borrowing to pay for something that decreases in value.
- Has unrealistic repayment plans.
- Borrowing for avoidable discretionary spending
- Raises your debt-to-income ratio too much.
Negatively affects your credit score.
Examples of good debt would include mortgages, home equity loans and HELOCs and, also to some extent, student loans. If you use a HELOC for home improvement, for example, you may still be able to deduct the interest if the money is used for improving your residence. HELOCs, just like your primary mortgage, are backed by your property. Student loans often come with lower interest rates and greater flexibility — plus investing in your education could boost your career opportunities and income (albeit at a cost).
Examples of “bad” debt could include longer-term auto loans (you’re buying a depreciating asset), credit cards (which levy high interest charges if balances are carried), certain kinds of personal loans and payday loans or title loans.
The Bottom Line
Not all debt is created equal. And the differences between good debt and bad debt aren’t always absolute. An unaffordable mortgage is probably a bad debt. On the other hand, a $900 loan to pay for your root canal is probably a good reason to borrow.
That said, having $100,000 in mortgage debt is very different from having $100,000 in credit card debt. The bottom line is that mortgage debt can deliver long-term financial gains at a lower cost of borrowing as you enjoy the benefits of homeownership and home value increases over time. Non-mortgage debt can also be beneficial if managed wisely, but it’s generally more costly and viewed less positively — and with higher risk — by lenders.
