Good Debt vs. Bad Debt

Debt is notoriously complicated. People all over the country are doing everything they can to get rid of it — and avoid racking up more. But, we can actually use good debt to our advantage. 

Yes, there’s such a thing as good debt. 

Debt can work as a tool to build wealth, increase your credit score, invest in your future and more when used responsibly. Let’s take a look at the difference between the bad and good debt and how you can use it to your advantage. 

What Is Good Debt?

The key to identifying good debt versus bad debt is understanding its purpose. Good debt helps build net worth with large investments (like a home) or further your career goals (like student loans). In the end, it should provide value.

Examples of Good Debt

In case you still don’t believe us, here’s what it might look like:

• Mortgage: Real estate can serve as an investment into your future. Instead of renting, you’re now putting your money toward something that could make you money in the future. However, it’s still very possible to become “house poor.” This happens when someone gets tangled up in a mortgage they can barely afford. Determining how much of your monthly payment goes to your mortgage will depend on your financial goals, current debt and lifestyle. One method, suggested by Chase Bank, is to calculate 25% of your post-tax monthly income to determine how much you could comfortably pay for a mortgage each month. For example, if you make $6,000 per month, multiply that by 0.25. That gives you a budget of $1,500 per month.
• Continuing education: Student loans have gotten a bad rap, even though 43 million Americans hold some level of student debt. Student loans allow you to pursue a career that requires a degree that you otherwise couldn’t afford. You do still have to be smart about it. Though higher education can lead to more earning potential, it’s not always the case. Do some research on your chosen career path to see how much post-secondary education you truly need to be successful.
• Launching a business: If you have an entrepreneurial spirit, a loan to start or maintain a business is an investment into your future. You can either build the business as a lifelong career or with the goal of selling it.
• Manageable credit card debt: In most cases, you’ll need a good credit score to get a loan for a house, car or business. You can build up your credit by responsibly using a credit card and paying off the balance every month. Some credit cards offer rewards like travel points or cash back, so you’ll be rewarded in more ways than one.            

You can also use good debt to finance large purchases, like a car or home upgrades. However, any time you hop on the debt train, it’s important to be realistic about what you can pay back.   

What Is Bad Debt? 

Now, bad debt is what you’ve heard horror stories about. It has high interest rates that make you feel like a hamster on a runaway wheel. You funnel all your extra income to it. And still, debt collectors start calling your office. Unfortunately, Americans have gotten comfortable carrying debt. The average personal loan balance per U.S. consumer was at $11,281 in 2023, according to Transunion credit monitoring.

Examples of Bad Debt

What was once good debt can end up as bad debt — or it can be that way from the jump. These are some examples of where you are most likely to encounter bad debt: 

• Credit cards: We know that strategic credit card use can be a good thing, but unfortunately, it can also give consumers a false sense of security with their spending. Credit cards with high interest rates can quickly turn a $100 purchase into much more when payments are spread out over several months. Plus, many credit cards carry annual fees. If you can’t manage to pay off your credit card balance every single month, avoid credit cards. 
• Payday loans: When you are short on funds and anxiously waiting for payday, a payday loan can look appealing — especially if an emergency comes up. Payday loans aren’t quite as simple as the “cash now” they advertise. Lenders may charge up to a 400% APR (annual percentage rate) with only two weeks to pay it back. If you can’t pay in full, you may be put under heavy stress to get such a loan paid back.
• Upside-down loans: The housing market can be fickle. If you purchased your home while prices were high then your house value falls below what you purchased it for, you might be “upside down” on your loan. This means if you sell your house, you would still have a balance left on your loan — which you have to pay. The same scenario can happen with a car loan.
  If you find yourself “upside down” on your mortgage, you might want to stay put for as long as you can while you pay down your loan or the tides of the market change. If you have to move, talk to your real estate agent. They may have options for renting out your house to turn it into a source of income while you wait out the market. 
• Car title loans: This is another way people like to get cash fast. Essentially, you give a lender the title of your car as collateral in exchange for cash. The lender now owns your car. If you fail to make loan payments, they can seize it and sell it to cover your loan balance. Losing access to your car is no joke, so avoid car title loans if you can.   

Strategies for Staying Out of Debt

If you’re worried about your good debt turning into bad debt, or it’s already gotten there, these strategies can help. 

Start Saving Today

Debt can often get out of control during times of crisis. Even if it’s a little bit, budget to put some money into your rainy day fund. It’s a good idea to have three to six months worth of expenses in your savings account. While that feels like a lofty goal, start small and add what you can each month. 

Pay Down Costly Debt First

Take a look at your sources of debt and tackle the debt that is costing you the most first. This could be a high-interest credit card or a medical bill with a high monthly payment. Freeing up the money to pay down smaller balances can speed up your debt-free journey. And avoid these costly mistakes when paying down credit cards.

Snowball Method

You can try the “snowball” approach. For example, if you owe $350 each month to your credit card company, $225 to your car loan and $175 on another credit card, you can focus on paying down your smaller credit card first. Once you pay it off, put that extra $175 per month toward paying down your car loan. Continue that pattern until you now have an extra $400 going toward the balance of your credit card debt. 

Get Realistic About Your Budget

A budget can help you build a good relationship with money. It doesn’t have to be restrictive, but a tool to help you reach your financial goals. Budget for savings, debt payments, and living expenses and be realistic about what you spend in other categories. 

If you can live frugally for a short while, you can unburden yourself from the pressure of bad debt and help your good debt stay that way.