Good debt vs. bad debt: How different debts affect your finances

While debt has become a fact of life for most, not all debt is created equal. Using debt irresponsibly could have dire financial consequences, but it can also be a wealth-building tool when managed properly.

Most experts categorize debt into two categories: good debt and bad debt. Essentially, a good debt is one that can increase in value over time. Bad debts are ones where you are unlikely to recoup the amount spent on interest.

Good debt vs. bad debt

Good debt and bad debt are distinguished by whether the cost being financed could increase in value.

What is good debt?

Any type of debt that can help you increase your net worth and build wealth is considered good debt.

You might carry good debt in the form of a student loan that helps you afford an education that will jumpstart a lucrative career, a mortgage that will eventually be paid off and leave you with the deed to your home or a business loan that will give you the capital you need to build a successful business.

While you’ll still have a regular payment to factor into your budget, “good debt” pays off in the end. It’s an investment that increases in value over time.

However, good debt isn’t without risk if you overdo it. You should follow a few steps to mitigate that risk.

• Shop around for the lowest interest rate possible.
• Research possible protections and payment plans available to you.
• Create a timeline to hold yourself accountable to your repayment plan.

What is bad debt?

Any high-interest consumer debt that doesn’t help you meet your long-term financial goals is considered bad debt.

On the opposite end of the spectrum, some forms of debt can lead to greater financial obstacles down the line. Bad debt often includes financial burdens like a high-interest credit card that you constantly carry a balance on, an auto loan with a lengthy term or a store credit card that could tempt you to overspend.

What separates good debt from bad debt is that bad debt funds depreciating assets, while good debt can give you access to an asset that will increase in value over time. In terms of interest rates, bad debt tends to carry higher interest rates than good debt.

You could find yourself in a position where you’re paying more than the asset is worth because you’re stretching repayment over a long time at a steep interest rate. Taking on too much bad debt could make it difficult for you to dig yourself out from under it later.

Is it okay to have good debt and bad debt?

Taking on both good and bad debt is unavoidable for most people. Good debt is preferable because it builds value, but there are cases where bad debt is the best choice.

For instance, using a loan to buy a reliable car to get you to and from work is a good use of bad debt. Even though the car will depreciate over time, paying interest on a loan will be one of the few ways you can finance a vehicle.

Ideally, you want to limit yourself to mostly good debt that you can afford to repay. Otherwise, the debt once categorized as “good” could quickly become problematic for your financial situation.

Bad debt happens, but it’s not the end of the world. What’s most important is that you plan to minimize those balances, particularly on credit cards.

How can I protect my finances if I have bad debt?

If you have bad debt, you can protect your finances by managing it properly.

An auto loan isn’t necessarily a bad financial move if you use your vehicle to travel to and from work — and the financing terms are competitive. However, credit cards are another story and can harm your finances if not kept under control and paid off each billing cycle.

The upside is you can take the necessary steps to shield yourself from financial hardship. Start by committing yourself to stop using credit cards to make purchases. Review your spending plan and identify ways to free up funds to pay down your credit card balances faster. Once you have a figure, create a debt payoff plan that works for you — the debt snowball and debt avalanche are two popular options.

It’s equally important to create an emergency fund so you’re not forced to resort to swiping them again and racking up even more debt should a financial emergency arise.

Bottom line

Making the decision to take on more debt is personal and requires homework to determine whether you’ll get more out of that debt than you put in. Once you’ve factored in the principal payment, interest rate, potential late fees and penalties, weigh those numbers against the value of your asset on the other side of repayment. This will help you gauge whether or not this new debt is good or bad for your finances.