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Bad debt has the potential to rapidly get out of hand and harm your financial health. In contrast, 'good' debt can be an asset, aiding in the growth of your net worth. Understanding the difference between the two types of debt is crucial for making informed financial decisions.
While excessive bad debt can wreak havoc, responsible borrowing through good debt can contribute to long-term wealth. Here’s a breakdown of the differences between good and bad debt and how to assess the debt you’re taking on.
How to Identify if Your Debt is Beneficial
Debt can be viewed as beneficial if it has the potential to improve your long-term financial well-being. But how can you be certain that will happen?
Since we can't predict the future, the simplest way to determine if debt is good or bad is by examining the interest rate. Good debt generally carries a low interest rate, usually under 6%. This explains why credit card debt is one of the most harmful types of debt: The high interest rates on credit cards can cause your debt to snowball as interest accumulates.
In addition to a low interest rate, it’s important to consider how your debt is secured. Secured debt is backed by collateral, while unsecured debt is not. Secured debt is considered 'good' because the asset you're financing serves as collateral for the lender—like your home with a mortgage, or your car with an auto loan. If you fail to make payments, the lender can seize the asset to recover some of the owed money. On the other hand, credit card debt and medical bills are examples of unsecured (i.e., bad) debt. The absence of collateral is why these types of debt typically have higher interest rates.
What exactly does good debt look like? In simple terms, if it boosts your net worth, it qualifies as 'good' debt. Mortgages are often cited as prime examples, as they tend to have lower interest rates and contribute to your overall wealth through home ownership and appreciation in value. Other examples of good debt include investing in real estate or starting a small business. In these cases, you’re borrowing money to fund an asset that will generate profits over time, meaning the debt can ultimately enhance your financial situation.
Closing thoughts
However, the situation is not always straightforward. Assessing your debt can become complicated with things like student loans, which can be significant and carry high interest rates. But in theory, these loans could lead to higher earnings and an increase in your net worth over time. Similarly, car loans can be tricky: While the loan is secured, which is beneficial, the car’s value quickly decreases. If you must take on debt to purchase a vehicle, aim for a loan with low or no interest.
It’s much clearer when it comes to identifying truly harmful debt, such as a high-interest loan on an asset that loses value over time. If you’re borrowing money for something that won’t appreciate or generate income—like consumer goods—that’s a clear case of bad debt.
Ultimately, whether debt is good or bad depends on the borrower’s situation and how much risk they’re able to take on. Here’s our guide to getting organized to pull yourself out of debt. If you need professional guidance in reviewing and managing your debts, here’s our guide to hiring a financial advisor who won’t rip you off.
