Good Debt vs. Bad Debt: What’s the Difference?

A substantial (and obvious) case can be made that no debt is good debt and it’s better for people to have a debt-free financial record.

But borrowing money or taking out loans is how many of us are able to purchase big-ticket items — like a vehicle or a house.

Both of these loans are justifiable and can usually be considered essential, while also providing value to the person who has taken on the debt.

There is another end to this spectrum, however, which involves careless amounts of debt that can become hard to manage.

The distinctions between “good debt” and “bad debt” are nuanced.

Putting finances into these two categories can be an oversimplification.

What is Good Debt?

Good debt is often rationalized by the old adage “it takes money to make money.”

This means that if the debt you take on helps to generate income or build your net worth, it can be considered good debt.

If it can add value to your future, this debt can be beneficial. But, if there isn’t a valid reason for the debt, it could be harmful.

Good debt can include:

  • Education: Typically speaking, education and trade schools offer a greater earning potential. Investing in a college degree or technical trade can usually pay for itself within a few years of graduation.
    It’s worth noting that not all degrees are of equal value, so it’s wise to consider short- and long-term prospects.
  • Owning Real Estate or a Home: Residential real estate can be used to generate income by renting a home, which can become a good source of cash flow.
    Owning a home has its own perks. Owning and living in a home for a few decades gives owners time to make modern updates which can lead to selling the home for a profit. Homeowners can also enjoy tax breaks that are not available to renters.
  • Owning a Business: Starting a business is a substantial investment but falls under the category of good debt — but also comes with risks if you aren’t prepared.
    Even though it is hard work, being your own boss can be financially rewarding. If you choose a field that you are knowledgeable and passionate about, the venture could be a success.
  • Transportation: Depending on where you live and work, transportation could be essential. Investing in a reliable vehicle can make the daily commute easier than public transportation or ride shares.
    It can also mean accepting a secure job as you will have consistent, reliable transportation.But it’s important to stay within your budget, which might mean purchasing or leasing a vehicle that is more practical than flashy. A muscle car can be quite tempting but might not be the best financial decision.

What is Bad Debt?

In general terms, it is considered bad debt if money was borrowed to purchase something that depreciates in value. Meaning, if it won’t increase in value or bring meaningful value to your life, it is not worth the debt.

Bad debt can include:

  • Clothes & Consumables: It’s fair to say that clothes are a necessity but are typically not worth the face-value price. Food and furniture are also essential but going out to eat for every meal or buying a new couch every year is not a good way to manage your money.
    Of course, these items can be a necessity, but within reason.
    Unless you are able to pay off the debt immediately, using a high-interest credit card or taking out a loan for these expenses is not advisable.
  • Credit Cards: Although they can help build credit, owning a credit card can be dangerous if not handled properly.
    If you are not able to make the payment in full each month, interest rates and fees can add up quite quickly. Monthly fees could end up costing more than the actual charges.
    It’s best to save credit card purchases for emergencies.
  • Transportation: Much like clothes and home goods, owning or leasing a vehicle could be essential. But it can be tricky.
    Lists of must-have items can add up to a monthly cost that is beyond the budget. Does the budget have wiggle room or does the list of must-haves need to be re-evaluated?
    Or perhaps it’s a second, seasonal vehicle that has your attention. Is now the right time to take on another car payment or can it wait?

Those who opt for used vehicles need to be just as careful. Taking care of a used car could have unforeseen expenses, causing the owner to find a way to cover the costs.

Focus on Good Debt

Getting into the habit of managing good debt, understanding what bad debt looks like, and the impact both have on your financial future is essential.

Even if the debt is considered good debt, you should work to pay it off as quickly as possible.

Doing so looks good in the eyes of lenders during times like applying for a mortgage.

For help creating and sustaining a budget to keep your debt manageable and other financial tips, contact our financial advisors today.