Good debt vs. bad debt: What's the difference?
Managing debt wisely starts with knowing what types of debt you have. (iStock)
Debt is the result of borrowing money, whether you're taking out student loans to finance your education, getting a mortgage to buy a home or simply using a credit card to pick up groceries. While some types of debt are bad, there is such a thing as good debt. Here's how to tell them apart.
What's good debt?
Generally, debt can be considered good if it helps or benefits you in a positive way.
"Good debt is any debt that increases your net worth and/or will provide future returns," said Krystal Pino, certified public accountant and founder of Nomad Tax.
It's important to note, however, that good debt can turn into bad debt if it isn't managed properly. For example, paying late or defaulting on good debt can negatively affect your credit score if it's charged as bad debt.
Examples of good debt
Student loan debt is often characterized as good debt since you're making an investment in your education. Ideally, that investment pays off after you graduate and use your degree to land a good job. The reward for taking on student debt is a higher earning potential.
A mortgage is also considered good debt since it's attached to a specific asset, i.e. a home.
"Mortgages generally carry low-interest rates, and the long term allows for manageable monthly payments," said Pino. "The interest on a mortgage is also tax-deductible, and ideally the value of your home will increase over time, generating a return on your investment."
Business loans could also be categorized as good debt if taking out a loan allows you to scale and increase profits. Car loans or personal loans to pay medical debt could be considered good debt or neutral, depending on the interest rates you're paying.
What's bad debt?
Bad debt is the opposite of good debt in the sense that there's likely no long-term reward or benefit to taking it on. And the interest rates you pay on bad debt can make it a more expensive way to borrow.
HOW DOES DEBT CONSOLIDATION AFFECT YOUR CREDIT SCORE?
Examples of bad debt
Credit cards could be considered bad debt if they come with a high annual percentage rate (APR). If carrying a balance means paying 15 percent, 20 percent or more in interest for things that have no long-term value, such as dinner out, then that's a prime example of bad debt.
Alternative installment loans, such as payday or title loans, can also be added to the bad debt category. While these types of loans are convenient, they can be one of the most expensive ways to borrow owing to the high fees payday and title lenders charge.
Personal loans can be on the fence between good debt vs. bad debt. A low-interest personal loan to renovate your home and boost its value would be good debt. Getting a personal loan with a high APR to go on vacation, on the other hand, is bad debt.
How to manage good and bad debt
With good debt, such as a mortgage or student loans, the best ways to manage it include paying on time each month and looking for opportunities to reduce your costs of borrowing. Refinancing student loans to a lower rate, for instance, could save you money on interest while lowering your monthly payments. The same is true for refinancing a home loan.
With bad debt, such as credit cards, high-interest personal loans or installment loans, you should be looking at ways to pay down those bad debts.
In terms of how to get out of credit card debt, for example, you might consider a balance transfer to make it more affordable. A balance transfer may be the best way to consolidate credit card debt if you can do so at a 0 percent interest rate. Debt consolidation loans are also an option for paying off credit cards and other bad debts.
Are debt consolidation loans a good idea? Maybe, if you can get one at a low-interest rate and you're diligent about not creating additional bad debt.
The key with managing both good and bad debt, however, is being focused on paying it off.
"Just because debt is considered good debt doesn't mean you should carry it," said Pino. "And be sure that you're able to maintain minimum payments; defaulting can be detrimental to your credit score."