Good debt vs. bad debt

Carrying some debt has become a way of life for the average American. According to the Federal Reserve’s latest Quarterly Report on Household Debt and Credit, total household debt rose by $312 billion in the second quarter of 2022 to reach a staggering $16.15 trillion.

While debt has become a fact of life for most, it’s important to know 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. Here’s a

breakdown of a few different types of debt and which category they fall into.

Good debt vs. bad debt

What is good debt?

Think of good debt as any kind that can help you increase your net worth and build wealth.

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 rules of thumb to help you mitigate that risk. Shop around for the lowest interest rate possible, research possible protections and payment plans available to you and create a timeline to hold yourself accountable to your repayment plan.

What is bad debt?

On the opposite end of the spectrum, some forms of debt can lead to greater financial obstacles down the line.

Bad debt usually includes any high-interest consumer debt that doesn’t play a huge role in helping you meet your long-term financial goals. This could include a high-interest credit card that you constantly carry a balance on, an auto loan with lengthy terms or a store credit card that could tempt you to overspend.

What separates good debt from bad debt is that bad debt funds depreciate 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 out that payment over a long time at a steep interest rate. This is when taking on too much bad debt could make it more difficult for you to dig yourself out of the hole later on.

What should I consider when taking on debt?

While living a debt-free lifestyle is often the dream for many of us, it’s not always feasible. Debt can play a key role in your journey toward reaching major financial milestones like purchasing your first vehicle, becoming a homeowner or starting your own business. When weighing your options and determining if taking on extra debt is worth your while, there are a few questions you should ask yourself.

You’ll want to determine if you can afford the monthly payments on your student loan, mortgage or line of credit. If you find yourself in a position where making that monthly payment becomes too much of a burden, think through options for giving yourself a bit more financial breathing room.

Research payment plans available that could make your debt more manageable, potential late fees you could face if you miss a payment, and debt relief programs that could help you stay afloat if you cannot pay back the money you borrowed. Prepare for the worst-case scenario and determine if the reward of having access to those extra funds outweighs the risk.

Last, but certainly not least, you’ll need to figure out how this extra debt will help you long-term. Once you’ve paid off your debt, you don’t want to be left empty-handed with a depreciated asset that doesn’t hold much value.

Is it okay to have good debt and bad debt?

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 often happens, but it’s not the end of the world. However, what’s most important is that you plan to minimize those balances, particularly on credit cards. But it could be worthwhile if you’re considering bad debt to make a purchase that will benefit you in the future.

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 eventually paid off.

The upside is you can take the necessary steps to shield yourself from financial ruin. Start by committing yourself to stop using credit cards to make purchases. Also, visit 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.

The bottom line

Making the decision to take on more debt is personal and requires a bit of homework to determine whether or not 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, and weigh those numbers against the value of your asset on the other side of repayment, you’ll be able to better gauge whether or not this new debt makes sense for you.