What’s the Difference Between Good Debt and Bad Debt?

Debt is a part of many people’s financial lives, but not all debt is the same. Some types of debt can help you reach important goals, while others can make it harder to manage your money. Knowing the difference between good debt and bad debt is an important step in building a healthy financial future.

Understanding Good Debt vs. Bad Debt

Good debt is money you borrow for something that can increase your long-term financial well-being or help you build value over time. It’s usually tied to investments in your future, like education or buying a home. Good debt often comes with lower interest rates and clear benefits.

Bad debt, on the other hand, is borrowing for things that lose value quickly or don’t improve your financial situation. Bad debt often comes with high interest rates and can make it harder to reach your goals if not managed carefully.

Why does this matter?

Understanding the purpose of money and how debt fits into your financial picture is a key part of personal finance.

Examples of Good Debt

Good debt is usually tied to things that can help you earn more money, build wealth, or improve your quality of life in the long run. Here are some common examples:

Education Loans

• Why it can be good: Borrowing to pay for college or job training can help you qualify for better jobs and higher income over your lifetime.
• Things to consider: Not all education loans are equal—look for reasonable interest rates and only borrow what you need.

Home Mortgages

• Why it can be good: Buying a home with a mortgage lets you build equity (ownership) over time. Homes can also increase in value.
• Things to consider: Make sure the monthly payments fit your budget, and understand all the costs involved.

Small Business Loans

• Why it can be good: Borrowing to start or expand a business can lead to higher income if the business succeeds.
• Things to consider: There are risks—make sure you have a solid plan and understand the terms.

Examples of Bad Debt

Bad debt is usually tied to purchases that don’t grow in value or help you earn more. It often comes with high interest rates that can quickly add up.

High-Interest Credit Cards

• Why it’s risky: Using credit cards for everyday expenses or things you can’t afford to pay off right away can lead to large interest charges.
• Example: Buying a $500 TV on a credit card and only making minimum payments can cost you much more over time.

Payday or Short-Term Loans

• Why it’s risky: These loans often have extremely high fees and interest rates, making it hard to pay them back without falling further into debt.

Borrowing for Unnecessary Purchases

• Why it’s risky: Taking out loans or using credit for things you don’t need—like luxury items, vacations, or frequent shopping—can strain your budget and limit your ability to save.

How to Decide If Debt Is Worth It

Before you borrow, ask yourself these questions:

1. Does this purchase help me build long-term value or income?
   • If yes, it might be good debt.
2. Is there a clear plan to pay it back?
   • Make sure you know how you’ll handle the payments.
3. What is the interest rate and total cost?
   • Higher rates mean you’ll pay more over time.
4. Can I afford the payments without sacrificing my needs?
   • Don’t borrow if it means you can’t cover essentials like housing, food, or savings.

If the debt helps you reach a goal and fits your budget, it may be a reasonable choice. If it’s for something you don’t need or can’t afford, it’s likely bad debt.

Tips for Avoiding Bad Debt

• Budget first: Know your income and expenses before taking on new debt. (See the pillar article below for the broader context.)
• Borrow only what you need: Don’t be tempted to take out more than necessary.
• Pay on time: Avoid late fees and extra interest by making payments before the due date.
• Read the fine print: Understand the interest rate, fees, and repayment terms before you sign.
• Build an emergency fund: Having savings can help you avoid borrowing for unexpected expenses.

Key Takeaways

• Good debt can help you invest in your future—like education, a home, or a business.
• Bad debt is often tied to high-interest borrowing for things that lose value quickly or aren’t essential.
• Always consider the purpose, cost, and your ability to repay before taking on debt.