What is good debt vs bad debt

Before you take on any debt, consider whether a car loan or new credit card will help meet your financial goals — or make them more difficult to accomplish. The type of debt you take on, along with its quantity and cost, can mean the difference between good debt and bad debt.

A credit card, for example, can be a means to financing large expenses and earning reward points. But if not managed carefully, credit card debt with high interest can spiral out of control.

Here are general guidelines on good debt and bad debt, how to handle each one and what to do if you’re facing too much debt.

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Low-interest debt that helps you increase your income or net worth are examples of good debt. But too much of any kind of debt — no matter the opportunity it might create — can turn it into bad debt.

Medical debt, for example, doesn’t neatly fall into the “good” or “bad” debt category. It’s an expense that’s largely uncontrollable and often doesn’t have an interest rate. You have a few ways to pay off medical bills.

Typically regarded as an investment in your future, student loans tend to have lower interest rates, especially if they’re federal student loans.

• Guideline: In general, aim for your student loan payment to stay below 10% of your projected after-tax monthly income a year after graduating. For someone who expects to earn $50,000 a year, the borrowing cap would be $29,000.

• Take action: To handle overwhelming student loans, look into repayment options such as refinancing and income-driven repayment plans.

Likely the biggest financial decision you’ll make, a mortgage is the path to homeownership.

• Take action: Downsizing, refinancing or moving to a lower-cost area can make housing costs more manageable.

For many, a car is essential for everyday life.

• Guideline: Keep total auto costs, including your car loan payment, within 20% of your take-home pay. Loan terms should be four years or fewer, preferably with a 20% down payment.

• Take action: Refinancing or trading in an unaffordable car can help you manage car expenses.

Expensive debts that drag down your financial situation are considered bad debt. Examples include debts with high or variable interest rates, especially when used for discretionary expenses or things that lose value.

Sometimes, bad debts are just good debts gone awry. Credit card debt is an example of this: If you have a high-interest credit card and pay off your balance each month, no problem. But if high-interest credit card debt builds up, you could be in trouble.

High-interest credit cards

High interest rates, such as those greater than 20%, can make your debts more expensive.

• Guideline: If you’re not making progress on your credit card debt, despite paying all you can monthly, that may be a sign you’re facing problematic credit card debt.

• Take action: If you can keep your spending under control, try out the debt snowball method, where you pay off your smallest debts first. A balance transfer credit card can make your credit card debt more affordable, though you’ll need good credit to qualify. Otherwise, a debt management plan from a nonprofit credit counseling agency might be a good option.

Personal loans for discretionary purchases

Taking on debt for expenses like a vacation or new clothes can be an expensive habit.

• Guideline: Personal loans can be a good option if you have a specific goal in mind, such as consolidating debt.

• Take action: If you’re facing an expensive personal loan, you may be able to refinance it.

Payday loans are a bad debt that can turn toxic: They often come with interest rates as high as 300% that can make them immediately unaffordable. These are short-term, small-amount loans meant to be repaid with your next paycheck.

• Guideline: Financial experts caution against payday loans because borrowers can easily fall into a debt cycle.

• Take action: Consider alternatives such as borrowing from a credit union or asking family members for help.

  As a general rule, don't borrow more money than you can handle. Borrowing money is a lot easier than paying it back. Smart borrowing can be convenient and help you achieve important goals like buying a home, buying a car, or going to college. Having too much debt can make it difficult to save and put additional strain on your budget. Consider the total costs before you borrow—and not just the monthly payment.

  It might sound strange, but not all debt is "bad." Certain types of debt can actually provide opportunities to improve your financial future.

  To make smart decisions about if, when, and how much to borrow, you need to understand the difference between "good" and "bad" debt and how to manage it. That way, you can avoid being part of the negative debt statistics in America:

  • Total housing debt is about $10 trillion and non-housing debt nearly $4 trillion.i
     
  • Americans are paying an average credit card interest rate of 17%.ii 
     
  • The average household with debt owes $6,506 on their credit cards.iii
     
  • Almost half of Americans carry a balance on their credit cards.iv
     
  • About a third of auto loans for new vehicles taken in the first half of 2019 had terms of longer than six years.v

  It pays to pay off debt.

  

  It pays to pay off debt.

  While it's important to save, it's even more important to pay off non-deductible, high-interest debt, like your credit card balance, as fast as possible. Using some of your savings to pay off this kind of debt can actually be the most cost-effective way to help you spend less over time.

  It's not all bad

  Good debt should ideally be in low amounts, low cost, help you achieve your financial goals, and have potential tax advantages. Here are two examples:

  • With mortgages, interest rates are low compared to other types of consumer debt, and owning your own home can help you build wealth over time as well as improve your quality of life. For example, it could shorten your commute or allow you to move into a better neighborhood or school district. Mortgage interest may be deductible. If you use a home equity line of credit or HELOC for home improvement, you may still be able to deduct the interest if the money is used for improving your residence. As always, be sure to check with your tax advisor.
     
  • With student loans, rates are comparatively low, and interest can be tax-deductible, depending on your income. Benefits include enhanced career opportunities, which may increase your earning potential in the long run.

  How to Pay Off Debt

  

  Watch video: How to Pay Off Debt

  On this episode of Personal Finance 101, we take a look at Schwab’s suggestions for how to manage your debt wisely.

  What is an example of good debt?

  In addition, "good" debt can be a loan used to finance something that will offer a good return on the investment. Examples of good debt may include: Your mortgage. You borrow money to pay for a home in hopes that by the time your mortgage is paid off, your home will be worth more.

  How can you tell the difference between good debt and bad debt?

  Key Takeaways. Good debt has the potential to increase your net worth or enhance your life in an important way. Bad debt involves borrowing money to purchase rapidly depreciating assets or only for the purpose of consumption.

  What are examples of bad debt?

  Bad Debt Examples.

  Credit Card Debt. Owing money on your credit card is one of the most common types of bad debt. ... .

  Auto Loans. Buying a car might seem like a worthwhile purchase, but auto loans are considered bad debt. ... .

  Personal Loans. ... .

  Payday Loans. ... .

  Loan Shark Deals..

  What is a good bad debt rate?

  In general, many investors look for a company to have a debt ratio between 0.3 and 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better, while a debt ratio of 0.6 or higher makes it more difficult to borrow money.