How to Tell 'Good' Debt From 'Bad'
How to Tell 'Good' Debt From 'Bad'
Debt is a scary word, but it's a necessary part of moving through the world today. If you want to rent an apartment, buy a car, take out a loan, or make pretty much any major financial move--you need to get used to debt. The good news: There is a such thing as good debt.
While bad debt can quickly spiral out of control and tank your financial picture, "good" debt can help you increase your net worth. Here's what to know about what makes debt good versus bad, and how you can better understand what type of debt you're taking on.
How to tell if your debt is good
Debt can be considered good if it has the potential to benefit your long-term financial health. But how can you ever be sure that's going to happen?
Without the ability to gaze into the future, the easiest way to tell whether debt is good or bad is the interest rate. Good debt will have a low interest or annual percentage rate (APR), typically under 6%. This accounts for why credit card debt is one of the worst kinds out there: The high interest rates on credit cards make it all too easy for your debt to get worse and worse as interest accrues.
On top of a low interest rate, look at how your debt is secured. Secured debt is tied to collateral, whereas unsecured debt is not. Secured debt is "good" because the thing you're financing becomes collateral for the lender--like your house for a mortgage, or your car for an auto loan (more on that below). So if you can't make your payments, the lender can seize your house or car and at least recoup some of the money owed. Credit card balances or medical bills, on the other hand, as classic examples of unsecured (aka bad) debt; the lack of collateral is exactly why these types of debt tend to have higher interest rates (again: also bad).
So what does good debt looks like? To sum it up simply: If it increases your net worth, the debt can be consider "good." That's why for most of their history, mortgages have been a prime example of good debt, since they usually have lower interest rates and grow your overall wealth (through gradual ownership of your home and increases in value). Other classic examples of good debt include investing in real estate or a small business. The reasoning is that you're borrowing money for an asset that will turn a profit in the long run; so even though you're in debt now, this debt has the potential to significantly enhance your finances.
Then again, it's not always so simple. Evaluating your debt gets tricky with something like student loans, which are often extensive and have high interest rates, but in theory will allow you to become a higher-income earner and increase your net worth over time. Car loans fall in this same category: Although the loan may be secure, which is good, the asset rapidly depreciates. If you need to go into debt to buy a car, look for a loan with low or no interest.
What's more black-and-white is identifying truly bad debt, like a high-interest loan on a depreciating asset. If you're borrowing money for something that won't go up in value or generate income--think consumer goods--that's a recipe for bad debt.
Ultimately, what makes debt good or bad depends on the individual lender, and how much they can afford to lose. Here's our guide to getting organized to pull yourself out of debt. If you need a professional opinion for reviewing and managing your debts, here's our guide to hiring a financial advisor who won't rip you off.