Good Debt vs. Bad Debt: Know the Difference
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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.
What is good debt?
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.
Guideline: Know how much house you can afford before shopping, and limit a mortgage payment to 36% of your income.
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.
What is bad debt?
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.