Good vs. bad debt: How to tell the difference

Debt can be your ally or your enemy. 

Debt may be a word that almost no one likes, but it's one many know well. The average consumer in many developed countries may carry significant credit card debt. Having said this, debt isn't always high interest or fast multiplying or what people classify as “bad debt”. In fact, certain kinds of loans are recognized by some as “good debt”. Good debt is seen as a tool for building your financial future.  

Here's how to tell the difference between good debt and bad debt, plus how to minimize any bad debt you may have. 

What is good debt? 

Good debt is generally considered any debt that may help you increase your net worth or generate future income. Importantly, it typically has a low interest. Generally, high-interest loans are those with significantly higher interest rates than standard market interest rates in your country.  

Examples of good debt 

Education  

While student loans can be a financial burden, taking on debt to pay for education is generally considered “good debt” because more education can raise your future income. The typical graduate earns a higher salary per week than someone with a lower level of education. Graduates also may have a lower rate of unemployment. These factors may contribute to a significant difference in average lifetime earnings. That's why some consider student loans an investment in your future. 

However, it's important to note that for student loan debt to be considered “good”, it must meet a couple of criteria: 

• Low interest rates. Lower interest rates on student loans helps make them easier to pay off in the future. Government-backed student loans often have these kinds of interest rates, but not all private student loans do. Be sure to carefully evaluate the terms on any student loan debt you take on.
• Helps your short-term and long-term career prospects. Having even a rough estimate of what your income could be after graduation and throughout your career can help put your student debt in the context of your future finances. Taking on extensive, higher-interest student loans to pay for a degree that may only lead to a salary comparable to what you could already make, for instance, might not be beneficial. In certain cases, understanding whether you may have access to employer benefits or government programs to pay down student loans can help you make a wise decision. 

Home or property 

Mortgages are a type of loan used to buy a house or other property. Historically, they've been considered one of the safest forms of debt because they tend to have lower interest rates, and they can potentially help you build equity (think: gradual ownership of your home). 

The equity you can build in your home is important for a few reasons: 

1. Home equity can be a significant asset, with median values varying greatly by country and region.
2. Homes may appreciate, or gain, in value. Historically, home prices in many countries have appreciated significantly over time, although this varies greatly by region. As with any investment, though, past performance is no guarantee of future success, and a home may decrease in value, even below the amount you owe on a mortgage.
3. If you need or choose to, you may be able to borrow against the equity you've built in the form of a home loan or line of credit. 

Be sure to do research before signing on any contract especially for a mortgage, which can have a lot of variables. For example, you may be able to choose if your mortgage has a fixed or variable rate. Fixed-rate mortgages and variable-rate mortgages offer important tradeoffs—variable-rate mortgages are more complex and often offer lower initial rates but with the possibility of rate increases. If you're in the market, speak to a local estate agent in your country to learn more about the major considerations and decisions you may have to make. 

What is bad debt? 

Bad debt is debt used to finance purchases that won't increase your net worth or future income. In some cases, the debt may be used to buy things that depreciate. Bad debt often has a high interest rate now or a variable rate that could become high in the future, meaning you'll likely end up paying a premium for purchases that are worth less over time. 

Examples of bad debt 

Credit cards 

Credit cards make (over)spending easy because, psychologically, swiping is less painful than spending cash. But running up a credit card balance can create more pain later. 

Many adults carry substantial debt, often exceeding several months’ or years’ worth of income. Additionally, credit cards usually have high interest rates—sometimes well over 20%—making repayment costly. Then, because people often use credit to buy things that are quickly consumed, like food and clothing, they wind up with nothing to show for that debt. 

How can you avoid this type of bad debt? Make a plan to pay down credit card debt you have today, then start treating your credit card like a debit card. Only use it for purchases that you could pay for with the money in your bank account. Creating and keeping a budget can also help your spending, and working to build emergency savings of three to six months of expenses can help protect you from relying on credit cards in a pinch. 

Other high-interest loans  

Generally high-interest loans are those that have an interest rate significantly higher than standard market interest rates in your country. You may encounter them in the form of payday loans or certain personal loans. These loans may be difficult to pay back, which can make them even costlier as interest compounds and grows. If you are late on any payments, it can lead to even higher costs. Because of their interest rates alone, these types of loans should only be used in emergencies when all other options were already tried. To avoid having to rely on high-interest loans, you'll want to follow the same steps you would take to tackle credit card debt. Pay down any existing high-interest loans you have and aim to get emergency savings established as soon as possible to avoid taking out loans in the future.