Good Debt Versus Bad Debt: What's the Difference?
All debt is not created equal, according to financial advisors.
Although "debt" has a negative connotation, that's a one-sided characterization. Of course, there's no getting around the fact that when you owe money, you're in debt to a person or entity like a bank, but that's not always something to avoid; it all depends on the reason why you borrowed the money. Was it to pay for a big blowout wedding? Unfortunately, that's considered bad debt, but if you borrowed funds to purchase your first home, then that's considered good debt. Here, we asked a financial expert to explain the differences between good and bad debt.
What is good debt?
Our experts agree that good debt is nothing to be afraid of. "Good debt is tied to an asset that can grow in value over time," says Brittney Castro, Mint certified financial planner. You borrow money for something that will potentially increase your wealth or income. A mortgage is a great example of good debt. When you take out a mortgage to buy a home, you hope that the property's value will increase by the time you've entirely paid back the lender. As with all loans, making payments in full and on time is a must.
Another example? A home equity loan. "It could be considered good debt if the loan gives you the funds to renovate your home, which can increase in value in the future, "says Castro. "When it comes to home equity loans and lines of credit, always do your research on the pros and cons and make sure you are using the available funds responsibly."
Student loans are also forms of good debt because you're taking on debt to earn your college degree and eventually increase your lifetime earnings, says Castro. Having a college degree may open the door to better career opportunities and higher salaries. Last but not least, a small business loan would also fall into this category. Borrowing money to start a personal business venture is considered good debt. You're seeking a loan to grow your company, which is necessary to be successful.
What is bad debt?
Bad debt's reputation is well-deserved. This is a loan for something that doesn't provide a return on the investment, meaning you won't gain anything financially for having borrowed the money. Credit card debt also falls into this category. If you pay your balance in full every month, you can avoid bad debt, but if you can only pay the minimum or just a portion of the balance, it will affect your credit score. If you use a card with a high interest rate and don't pay the bill in full every month, it'll make matters even worse.
Car loans are also typically considered bad debt since a car loses its value the more you use it, says Castro. "However, don't let a bad debt label stop you from taking out a car loan. Just make sure you're realistic about your overall financial situation before taking on any debt." You don't want a loan payment that is so high you can't afford your lifestyle or to save for other goals like retirement.
Payday loans are also considered bad debt. This is a short-term loan to help cover your immediate cash needs until you get paid. Castro explains that payday loans typically charge high interest rates for short-term immediate credit; for example, repaying the loan within the span of only a few weeks-and are typically based on your income. They're available through storefront lenders or online, depending on your state. But Castro advises avoiding them. "They have outrageous interest rates and can very quickly add up if not repaid on time," she warns. "Payday loans are typically marketed to those who are in a financial emergency and need cash quickly but perhaps have poor credit or no savings."