Good debt vs. bad debt: What helps and what holds you back

The word debt often has negative connotations, but the truth is that debt can be much more nuanced than that. Debt can be a valuable tool, if used correctly. The key is understanding the difference between good and bad debt. So, how do you know the difference?

What is good debt?

Debt, when used properly, can be a form of leverage, meaning that you can gain access to assets or opportunities much greater than your current financial capacity. Here’s what you should be looking for when taking on good debt:

• Low interest: For debt to be good, the interest and payments need to be manageable.

• Asset: Use debt to purchase something that can appreciate in value, like a house, and can help you increase your net worth.

• Opportunity: Or, something that can produce income, like a rental property or business.

What can good debt do?

Good debt helps you get ahead in many ways, as long as you manage it properly. Along the way, you can build your credit and turn that loan into something of value with long-term growth.

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Examples of good debt

• Mortgages and home equity  

• Student or education loans, particularly when pursuing an educational path that’s likely to yield strong income opportunities

• Business loans, as long as your business is in good standing to be able to repay the loan

Many other forms of debt can be beneficial. For example, you may take out a loan to purchase a car to help you get to and from work, so you can increase your income. As long as it’s a loan with reasonable terms and a payment you can afford, this can be considered good debt. 

What is bad debt?

On the other hand, debt can quickly put someone in a bad situation if they’re not careful. Bad debt is when you overextend yourself financially, have high interest rates, and/or are generally taking on debt for wants instead of needs. Here are some warning signs that you might be taking on bad debt:

• High interest rates: Some forms of debt, like carrying a credit card balance, have such high rates that debtholders may end up paying far more in interest than the original amount they borrowed.

• Buying for consumption: Taking on debt for things you don’t need or things that don’t grow in value over time.

• Shaky repayment plan: If you don’t have a clear plan on how you will repay the debt, it could lead to financial challenges down the road. 

Why can bad debt be harmful?

Just like money can grow and compound for you when you are investing, debt can grow and compound against you if you have high interest or unmanageable payments. This can lead to damaging your credit score and spending money on interest payments that could be used for other things, like saving or investing. 

Examples of bad debt

• Using high-interest credit cards and not paying it off monthly

• Taking out payday loans or title loans

• Using debt to finance discretionary purchases, such as electronics or luxury items

• Having a long-term car note with high interest rates

How good debt can turn bad (and vice versa)

It’s hard to automatically categorize specific debt as good or bad. Circumstances can change, turning what seemed like good debt into bad. There are also situations where what looks like bad debt might actually not be as bad as it looks, or even beneficial.

Even the best intentions with good debt can become risky if you borrow too much, take on debt with higher interest rates, or do so without a reliable income or plan. Or, something unexpected can happen, like losing your job or encountering unexpected health issues, causing this good debt to be much more burdensome than it initially was. 

On the flip side, credit cards aren’t always bad. If you pay them off monthly, then you don’t need to worry about paying back interest payments. You could also be in a situation where you need a car, for example, and your only option is to take out a disadvantageous loan. If you go in with a plan to pay it off early, the high interest rates won’t be as harmful to you long term. 

Evaluate every situation where you’re planning to take on debt based on your personal finances and goals to determine what is likely going to be good debt or bad debt for you.

Questions to help you evaluate your debt

When evaluating whether debt might be good or bad for your situation, here are a few questions you can ask yourself:

• What is the interest rate? Is it low or high relative to the market?

• What is the purpose of the debt? Should it be considered an investment or consumption?

• What is the repayment timeframe? Is it realistic with your income?

• What’s the risk if something in your finances changes, such as a job loss or market downturn?

• Could you avoid taking on debt by saving more or using other resources?

Other factors to consider before taking on debt

Before making your decision, here are some additional things to consider:

• Hidden costs: Loans or credit cards may have hidden fees or penalties that could increase your payments.

• Psychology: Consider the mental and emotional effect the debt will have on you, including stress, especially if it will stretch your finances thin.

• Market changes: Shifts in the economy could affect how “good” your good debt is. For example, is the degree you’re taking out student loans to acquire going to still be relevant by the time you graduate? Could the direction of the housing market affect the value of your home?

• Credit score: Debt you take out now can impact your credit score, particularly if you have any challenges paying it back and on time. This could affect your future borrowing ability. 

Saving to pay for things in cash

Instead of turning to high-interest debt, families can get ahead by saving for purchases in advance. With Greenlight’s family money management app, kids and teens can set up savings goals to guide them toward building up cash for a future purchase. Parents can encourage smart money habits by showing their kids how small contributions add up over time, helping them see the benefits of paying with cash rather than borrowing.

Debt is what you make of it

Debt isn’t inherently good or bad, it’s what you make of it. Understand why you’re taking out the debt, the terms of the debt, and have a plan to pay it back to ensure you’re using debt as a tool to propel your finances forward. 

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