Good Debt vs Bad Debt: What’s the Difference?
“Good debt” seems like a bit of a misnomer. After all, debt is debt; it can destroy your credit score, reduce your chances of getting a house or a car and generally make life very difficult for you. But it does exist.
Think of it this way: A loan of $500 is always going to reduce your score, generate interest payments, and impact your debt-to-income ratio. The debt is the same regardless. But blowing that money on a lavish party or investing it in your future or two completely different things.
In this context, debt is good if you invest it wisely and bad if you don’t. With that in mind, let’s look at some different types of debt and see how they fit into this framework.
Good Debt vs Bad Debt
In simple terms, good debt is any type of debt that increases your net worth either indirectly or directly. Bad debt is anything used to purchase an asset that depreciates or has non-tangible value.
But before we look at some examples, it’s important to note that your lender generally doesn’t care what you perceive as good or bad debt. They’re not going to reduce the interest rate or be more lenient just because you insist that the vacation you dropped $5,000 on actually helps your career as an influencer.
This is just a concept that people use to differentiate types of debt, suggesting that borrowers should be more accepting of one and more wary of another. And just like the debt to income ratio, which is used by some lenders but isn’t recorded on your credit report, it’s a tool that can help you to better manage your finances.
Types of Good Debt
As the saying goes, “It takes money to make money”. Take a room full of newly successful young entrepreneurs, remove the ones funded by the Bank of Mom and Dad, the ones who struck gold with a single, once-in-a-generation idea, and you’ll be left with a room full of debtors.
It’s a home truth that every successful entrepreneur and start-up company learns, but one that many people outside these circles are unaware of. Having that debt doesn’t mean they’re not profitable or successful—it’s just a part of life. Tesla, Spotify, Uber—some of the biggest companies in the US run at massive losses, yet they’re still successful, their owners and CEOs still make millions, and there is a long line of investors desperate to join them.
Those losses aren’t plucked from the ether, they come from debt, from unfulfilled contractual obligations, government loans, and private loans. Entrepreneurs have huge debt because they have big assets and abundant finances, and they don’t use their millions to clear that debt for the same reason you don’t use your thousands to clear debts of hundreds—why bother when you can just keep meeting those monthly payments?
Student Loan Debt
Student loans account for just over 10% of all personal loan debt in the United States. As discussed in our Student Debt Statistics article, many students will default on those loans and the average clearance time is over 20 years.
If student loans are good debt, then what could possibly be bad, right?
But as detrimental as student loans are, they are also the main thing helping you to educate yourself and prepare for the future.
As an example, the average medical school debt is just under $200,000, with a quarter of all debtors carrying loans much higher than that. That’s a frightening sum of money, but once those students qualify and start working their way through their respective professions, they can earn it back tenfold.
The average salary for a medical doctor in the United States is between $70,000 and $400,000, and it’s projected to grow at a rate of 15% a year.
Those student loans aren’t looking so bad now, are they?
Say what you want about student loans and education in general, but a college-educated employee makes much more, on average, than their non-college-educated counterparts. They are also much more likely to find a job in the first place. Sure, there are millions of overeducated employees in the workforce, but their struggles would be far greater without that education.
Mortgages are one of the most common types of good debt. Every time you make payments on your home loan, you’re moving one step close to owning a sizable asset outright. You’ve also secured your place on the property ladder and can look forward to a much more prosperous and secure future.
If you keep meeting those monthly payments and even adding a little more where possible, you’ll gradually reduce that debt and your interest payments with it. If you then decide to buy another house, you can cash-in the equity that you have already cleared and use this to upgrade, thus climbing ever-higher on the ladder.
A home loan is one of the biggest and most important debts you will acquire in your lifetime and the sooner you get one the brighter your future will be.
Small Business Debt
You’ve probably heard the saying that 9 out of 10 start-ups fail. It’s sad but true—they don’t have the necessary cash flow to keep the doors open and are forced to borrow money, acquire large debts, and then eventually call it a day.
But while you might fail 90% of the time with a small business, you’ll fail 100% of the time if you spend your money and credit on a vacation instead.
Borrowing money for a business is considered good debt because you’re creating an opportunity for yourself, one that can increase your cash flow in the short-term and potentially lead to massive success in the long-term.
Small business debt can include credit cards and loans, but it’s important not to take opportunities from one asset and use them to build another. For instance, using an equity loan to fund a business will strip away good and stable debt and replace it with good and unstable debt, thus reducing your long-term financial expectations.
Why Should you Consider Accumulating Good Debt?
You should never accumulate debt just for the sake of it, even if it’s good debt. If you have other means of paying for college, use them; if you’re not ready for a mortgage and aren’t confident you’ll meet the payments, wait; if you don’t have a good business idea or the experience needed to follow through, find something else to do.
Good debt is only good debt when it actually leads to something. If you don’t have the money for mortgage payments then you’ll default, the house will be foreclosed, and your financial future will be in ruins. If you don’t have a good business idea or the sense to make it work, all those loans and business credit cards will default, and you may never run another business again.
Debt is always something that needs close and careful consideration. Weigh up the pros and the cons and make sure you have the money to pay for it and the will to make it work.
When Can Good Debt be Bad?
As discussed above, one of the ways good debt can become bad is if you take equity out of your home (a stable debt) and put it into a business (an unstable debt). There are still some benefits to doing this, especially if you’re able to continue making repayments on your equity loan without issue, but only if you’re confident the business will be a success and that’s not something you can accurately predict.
It’s a grey area, but the same can’t be said for debt acquired to make an investment. If, for instance, you acquire personal loans or credit cards purely to invest in stock, it’s bad debt. On the one hand, you have something tangible that can earn you a consistent profit, but on the other hand, it’s highly unlikely that the profits will cover the interest payments and there’s always a risk the investment will fail completely.
Kinds of Bad Debt
If good debt is the linchpin of modern entrepreneurial success, then bad debt is the catalyst that has brought so many citizens to their knees. As far as your net worth and future is concerned, it’s the equivalent of throwing money down the drain. It won’t improve your future cash flow or give you a useable, sellable asset, you’re just borrowing money that will quickly depreciate.
On the surface, a car loan might seem like good debt. It gives you a tangible asset that, initially at least, is worth the balance of the loan. However, it’s a car, not a first-edition novel, and it’s going to depreciate as soon as you drive it off the forecourt. This is true for classic cars as well—it doesn’t matter how much you try you convince yourself otherwise, the vast majority of cars will rapidly depreciate in value.
Not only are you paying over the odds for something that could be worth several thousand less as soon as you drive it home, but if you’re buying with an auto loan then you may also be paying a lot in interest.
According to official statistics, new cars depreciate by an average of 25% at the end of the first year and the average price of a new car in 2019 was $34,000. If we assume a $4,000 down payment and 5% interest over 5 years, that car will cost you $9,300 in the first year alone. At the end of the term, you’ll pay an extra $3,200 in interest and the car will have lost 60% of its value. If you sell at that point, you’ll have lost just under $25,000, plus maintenance fees.
If you need a car to get to work, buy a used one instead. New cars cost the most and depreciate the fastest—a used car can save you thousands and hold more of its value over the short-term.
Credit Card Debt
Credit card debt is rarely positive. You can use it to fund a business, but if that business goes bust, your debts remain and you’re essentially shouldering all the burdens of your businesses’ failure, which is why business loans are much better. The main use for credit cards is to buy items that people otherwise can’t afford, including designer clothes and technology.
A credit card allows you to access money that you don’t own and in combination with youth and/or impulsivity, this can create all kinds of problems. Credit card debt is severe because it comes with high-interest rates. That interest is compounded every day, which means you pay interest on interest, escalating the problem with each payment period.
A credit card is designed to bleed you dry. We don’t mean to sound melodramatic, but it’s true. They use rewards, cash back, and other perks to lure you into spending money you don’t have; charge you extortionate interest rates when you inevitably fail to clear your balance; demand penalty fees when you don’t make payments on time.
As millions of debtors can attest, as soon as you fail to clear that balance for the first time, whether because you’ve had a slow month, made a few big purchases or simply want to use your money for other things, it’s hard to get back on track. That’s what lenders rely on and it is why credit card debt is so bad.
Klarna, PayPal Credit, Affirm—these services are all there to convince you to buy. If you walk into a shop and find an expensive item that you can’t afford, you have to walk out or put it on a credit card. And if those cards are maxed out or your credit is too low or bad to qualify, you’ll have to live without. Thanks to these services, however, you can make that purchase now, when you’re at your most impulsive, and then worry about it later.
This is a trap that countless people are falling into and one that has done some serious damage to the credit scores of youngsters across the United States. This is all bad debt, because those Nike sneakers, that Supreme hoody or that brand-new iPad are not going to increase your worth or improve your financial future.
How Much Bad Debt is Too Much?
All bad debt should be avoided, but there will be times when you simply can’t escape it. In such cases, it’s best to try and keep it below 10% of your total debt. As an example, if your debt looks like this:
- $80,000 Home Loan
- $20,000 Student Loan Debt
- $10,000 Credit Card Debt
Then your bad debt accounts for 10% of your total debt. It’s also important to consider how much debt you have in relation to your income, known as your debt to income score. Mortgage lenders will look at this score to determine how likely you are to default on your payments, triggering what is often a very costly foreclosure process for them (as discussed in What Credit Score Do I Need for a Home Loan?).
Anything lower than 20% is ideal for your debt to income ratio and you won’t start to edge into dangerous territory until you pass 40%. In the above situation, assuming a monthly mortgage payment of $1,000, credit card interest of $200, and student loan repayments of $300, you would need an income of $5,000 to reach that 30% target ($1,000 + $200 + $300 = $1,500 and $1,500 is 30% of $5,000).
This accounts for both good debt and bad debt—a lender won’t care which is which.
Can You Transform Bad Debt into Good Debt?
If we use the acquired definition for what constitutes good and bad debt, then technically it’s possible to turn the latter into the former by using it to advance your financial future, but it all depends on the individual.
A new MacBook purchased with a personal loan is bad debt if you use it to play games and procrastinate, but not if you use it to sustain a career as a designer, writer, Youtuber or music producer. The former will use the machine, and therefore the debt, to waste their time and hurt their future finances; the latter will use it to earn money and improve their prospects.
A $3,000 Gibson Les Paul is a wise investment for a gigging musician who needs the best quality instruments, but not for a wannabee Rockstar who hasn’t yet learned how to play.
It’s entirely down to you. If you use the debt to improve your career and your prospects, it’s good debt; use it on something that will only cost you money and time and it’s bad debt.
Summary: Debt is Debt
Whether you consider your debt to be good or bad, the lender won’t care and will still punish you if you fail to make repayments. By all means, try to focus on acquiring good debt rather than bad, but don’t forget that it’s still debt, you’re still responsible for high-interest rates and penalty fees, and you’ll still suffer if you default.
A lender won’t care if you used your loan to further your career or to enjoy a few days in the sun, if you fail to pay, they’ll chase you, punish you and even sue you. So, never acquire any debt that you’re not 100% sure you can afford, even if it does qualify as “good debt”, and always prioritize those monthly payments while trying to pay more of the principal whenever you can.