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‘Good’ debt could help you meet your financial goals, while ‘bad’ debt may hinder your progress.
You may sometimes hear financial experts say it’s best to avoid debt altogether. But not all types of debt are created equal. In fact, some debt may help improve your financial situation over time.
For example, you may get student loans for school to boost your earning potential or a mortgage to buy a home in an up-and-coming neighborhood. These types of purchases may end up giving you a return on investment through a higher salary or home value.
On the other hand, using a high-interest credit card to treat yourself to a new wardrobe or fancy dinner could mean costly interest payments if you don’t pay off your balance on time and in full each month.
Let’s take a closer look at some of the differences between good and bad debt and how they may affect your finances.
What is ‘good’ debt?
Good debt is an investment that may boost your income or net worth in the future.
“Good debt can improve your long-term financial situation,” says Leona Edwards, a CFP and financial planner at Snow Creek Wealth Management in Nashville, Tennessee. She says having a payment plan you can afford is the best-case scenario.
Here are some examples of good debt that might pay off for borrowers.
As the cost of college continues to rise, student loan balances are increasing, too. But while you might not enjoy paying off that debt after graduation, the end result could be worth it. According to data from the Bureau of Labor Statistics, as of 2017 the median weekly earnings of college graduates was more than those with high school degrees.
For most people, buying a home means getting a mortgage to pay for it. You’ll benefit in the short term by securing a place for your family to live. And if the value goes up, you may be able to sell the property for more than you originally bought it for.
If you’re trying to launch or expand a business, you may have thought about applying for a small-business loan. If your business grows, you can use the income to support your family or maybe sell the company to make a profit.
“Being in business for yourself could be a great way to take charge of your career and financial future,” Edwards says.
What is ‘bad’ debt?
Bad debt doesn’t typically offer the same benefits as good debt. After months or years of making payments, you may not have anything of value to show for it. If your purchase doesn’t increase in value or the debt doesn’t help you make progress toward your financial goals, you may be taking on bad debt. To make matters worse, bad debt may come with short repayment terms — making it more difficult to pay off.
Here are some examples of debt that may get in the way of your financial progress.
High-interest credit card debt
When you’re short on cash, it may be tempting to swipe your credit card to pay for new clothes, dinner or even life essentials. But credit card debt can be costly — according to the Federal Reserve, average credit card interest rates were more than 15% in the first quarter of 2020.
“Credit cards are fine if you can cover your purchases by the end of each billing cycle. Otherwise, you will pay a premium for the privilege of carrying a balance,” Edwards says.
If you want to avoid purchase interest on your credit card, you need to pay off your balances on time and in full each month.
Payday loans or title loans
Short-term loans with high interest rates and fees, like payday loans or title loans, may get you into financial trouble. If you can’t pay off the loan according to its terms, you may be stuck taking out another loan, further adding to your balance.
Edwards says to avoid these types of loans whenever possible. “These loans should be the last lever you pull.”
Should I take on new debt?
Taking on debt is a big decision. Before applying to borrow money, here are some questions to ask yourself.
- How much of a monthly payment can I afford?
- Will my repayments affect other financial goals like building an emergency fund, buying a home or saving for retirement?
- What happens if I can’t make the payments?
- How much total interest will I pay over the life of the loan?
- After paying off the debt, what’s the final outcome? Will it boost my earning power? Will I own a valuable asset like a home?
Regardless of the type of debt you take on, you should set a budget and have a payoff plan before you take on any new debt. It’s important to make monthly payments on time and in full.
To stay on track with your financial goals, try to avoid debt with high interest rates that won’t advance your financial goals. Before you apply, check your credit scores and credit reports to see if you might be able to qualify for competitive rates and terms.