I am often asked about the difference between “good” debt and “bad” debt. I put them in quotes because using qualifiers tends to make people feel bad about themselves, and I want to avoid that. In my experience, all debt usually feels bad, because you owe someone else money, but not all debt is equal.
In my experience, all debt usually feels bad, because you owe someone else money, but not all debt is equal.
What is “good” debt?
This type of debt is considered an investment that will typically grow in value or generate income over time. Good debt also tends to have low interest rates. An example is student debt. The idea is that this debt will eventually result in higher income over the course of your life. Student loans (particularly federal loans) usually have lower interest rates and the interest that you pay on those loans is tax deductible.
Taking out a mortgage to buy a home is also considered good debt. Similar to student loans, mortgages tend to have lower interest rates, and that interest is also tax deductible. Ideally, your home would increase in value while you own it, so if you eventually sell it, you’ll earn back the interest that you paid.
Other examples of good debt are car loans and home equity loans. However, since cars lose value more quickly, it’s recommended that borrowers pay as much up front as possible to avoid paying a lot in interest over time.
What is “bad” debt?
“Bad” debt is any debt that is taken out to pay for things that lose value over time and don’t result in higher income. This type of debt also usually comes with high interest rates. Basically, you end up paying more than the cost of the original purchase. An example is credit card debt. If you keep a balance on your credit cards, the interest grows and makes it difficult to pay off the amount. You can get caught in a cycle that feels like it will never end.
Payday loans are also considered bad debt. These loans, in particular, usually turn out very negatively for the borrower. Interest rates and fees are sky-high and many people are unable to pay them back in time, and so the loan amount grows and grows. This can destroy a borrower’s credit and wipe out their bank account.
All this being said, having a credit card is not a bad thing. If you pay off your balance each month, your credit score will not be hurt. The problem arises when you have credit card debt over a long period of time, because you owe more and more to credit card companies. This can hurt your credit score and prevent you from building up savings. (Not to mention it will stress you out.)
The moral of the story is that we will all probably have debt at some point in our lives. Debt is not inherently bad. In fact, having credit history is really important when trying to build up your credit score. It’s just important that the debt you have is giving you something in return, rather than just emptying your bank account.
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Certified Financial Education Instructor. Feminist and financial coach for women. Founder of Money Circle.