What Is Good Debt vs. Bad Debt? Help Understanding the Difference

This article helps define and provide examples of good debt and bad debt, explain how you can avoid bad debt, and give you guidance on how debt could help you. Keep reading for more information on how to use debt to build a richer, more rewarding future.

What is good debt?
4 examples of good debt
What is bad debt?
2 examples of bad debt
How can you avoid bad debt?
How can debt help you?

What is good debt?

“Good debt” refers to borrowing that helps you reach personal or financial goals or improve your financial situation. These types of loans often have lower interest rates and may help you increase your net worth.

Imagine: Debra wants to open a small business she’s passionate about and build wealth for her family. To do so, she must take out a loan to get it up and running. Although she is technically taking on debt, this loan will help her business thrive and could eventually earn her more money long-term. In this example, Debra’s small business debt can be considered good debt.

4 examples of good debt

Here are several examples of good debt.

1. Mortgages

Mortgage debt is often considered good debt because it makes home ownership affordable and might help you improve your net worth.

A mortgage is secured using your house or other real estate property as collateral. A second mortgage, such as a home equity loan, lets you borrow from the difference between the current market value of your home and an existing mortgage.

When you purchase a home with the help of a mortgage that fits in your budget, you may build home equity over time. This equity becomes an asset that can be included in a calculation of your net worth. Equity is the value of your home after subtracting what you still owe the lender. The equity in your home is part of your net worth. As your equity grows, so does your net worth. So, when taking out a mortgage, buying a house can be considered good debt.

It’s important to figure out what you can afford before you apply for a mortgage. Look for a mortgage with a reasonable interest rate and repayment term, and make sure the monthly payments fit into your budget to help you maintain on-time payments.

2. Student loans

Student loans are another kind of good debt. Although rates for student loan debt may increase, they could be lower than for many other types of debt. Moreover, the education they help you pay for might advance your career. According to the U.S. Bureau of Labor Statistic, each level of education you complete may give you access to higher paying occupations—meaning a higher net worth over time.

College graduates tend to earn more than workers who have only a high school diploma, according to the U.S. Bureau of Labor Statistics. But student loans could also become a burden if they're too large or take too long to pay back.

To avoid this good debt turning into bad debt, try to balance what you pay for your education with what you expect to earn in your first year on the job. For example, if the starting salary in your first year out of school will be $60,000, you’d aim to limit your borrowing to $60,000.

This might help you pay back the loans within a 10–15 year period, depending on f your financial situation. Also, paying more than the minimum amount due may help you pay back the student loan debt sooner and save money on interest in the long run.

Another way student loans could be good debt is that interest on them might be tax deductible if you qualify, according to the Internal Revenue Service. Consult a tax advisor for more information based on your specific circumstances. If you have multiple loans, you might consider a student loan consolidation. But remember, consolidation may lengthen your repayment period, so you might end up paying more in interest.

3. Car loans

Depending on where you live, you might need a car for everyday life or to get to work.

It could make sense to borrow money to buy a car. But you should be smart about it—look at your entire financial picture to see what makes sense for you.

For example, choosing a car that is reliable and affordable, rather than the latest model, could help you find a repayment term and monthly payments that fit your budget.

Make sure you’re getting an affordable interest rate on your auto loan, and choose the shortest repayment term possible for your budget. Although a longer repayment term may lower your monthly payments, you might end up paying more in interest over the life of your loan.

4. Business loans

A low-interest-rate loan to help you launch a business may be well worth the expense if it allows you to pursue a passion and build wealth for yourself and your family.

A business loan might also help you take your business to the next level. You might use it to pay for things that would help your business expand, like providing cash flow for everyday expenses, buying equipment or commercial real estate, or increasing your marketing. A business loan may also help to build a good credit history, which can make more financing options available as your business grows.

Overall, debt can be considered good when it is taken out intentionally with the goal to better your long-term financial situation. But good debt management is important to ensure it doesn’t turn into bad debt.

What is bad debt?

“Bad debt” refers to loans with higher interest rates and fees that prevent you from making progress toward your financial goals. This kind of debt often feels like a burden and may leave you feeling overwhelmed. Too much debt may damage your credit score and make it difficult to access credit when you need it.

Now picture Debra in a different situation. She begins spending on a credit card without a proper budget. This leads to her making purchases she can’t afford. Due to her rising bill and high interest rate, Debra starts missing payments. This in turn negatively affects her credit score and hurts her financial goals. This is when debt can be considered bad

2 examples of bad debt

Some examples of bad debt include higher-interest-rate types of credit and payday loans.

1. Higher-interest-rate credit cards

There is nothing bad about using credit cards. In fact, using a credit card for purchases you can afford and paying at least the required minimum payment each month may help you build credit and improve your credit score.

But credit card debt may turn into bad debt if you overspend or don’t pay at least your minimum monthly payment. Missing payments or paying your bill late may harm your credit score and make it difficult to get credit in the future. What’s more, credit cards may charge a higher interest rate than other types of loans.

Dealing with this type of debt starts with making a plan for paying it off. One effective way to do this is by consolidating your higher-interest credit card balances into one personal loan with a lower interest rate.

That may make your debt more manageable and help you pay it off faster, bringing you closer to your goal of being debt free. In fact, 85% of surveyed customers told us taking out a Discover personal loan for debt consolidation helped improve their financial future.*

2. Payday loans

Also called cash advances, payday loans are usually short-term, high-interest loans for small amounts that you must pay back quickly—typically by your next payday. If you can, it may be best to avoid payday loans. They might not help with money problems and could even make things trickier.

A payday loan often charges fees for lending you money. A $15 fee for every $100 you borrow is common. If you borrow $300 and pay back $345 in two weeks, which includes the fee, that is equal to an annual percentage rate of almost 400%.¹

Also, even if you pay back the loan on time, it may not help your credit score. That’s because payday loans generally aren’t reported to the credit bureaus.²However, if you become delinquent on your loan, a collection agency might report that.

How can you avoid bad debt?

The good news is that it’s possible to change bad debt into good debt and make progress toward your financial goals. The first step is getting a clear picture of what you owe to each lender. Then you can decide the best way to wipe out those debts.

Balance transfer credit card

One option is a credit card with a balance transfer offer. These cards let you transfer the balance of one card to another, often with a zero-interest introductory period. Just remember, once the interest-free period ends, you likely will be charged the standard interest rate on whatever balance is left.

Balance transfers may be good short-term solutions for smaller debts—if you’re able to pay off the balance within the zero-interest period.

Debt-consolidation loan

Another solution may be a personal loan for debt consolidation. There are several benefits to a personal loan:

You can lock in a fixed interest rate, so your monthly payments don’t change.
You could simplify your finances with one set regular monthly payment to one lender, instead of managing several different loans or credit card balances with different payment amounts and due dates.
And, maybe, the best benefit? Because a personal loan is an installment loan, you will know exactly when your loan will be paid off. Discover Personal Loans lets you choose how long you’d like to repay your loan—from 36 up to 84 months. With Discover Personal Loans, for example, if you get approved for a $15,000 loan at 11.99% APR for a term of 72 months, you’ll pay just $293 per month.

Credit counseling

If you’re struggling to keep up with higher-interest debt and need help sorting through your options, you may think about working with a credit counselor. A credit counselor is a trained professional who can provide expert guidance on how to budget, negotiate with creditors, and create a debt management plan. There are organizations like the Consumer Protection Financial Bureau that can help you find an accredited credit counseling agency.³

How can debt help you?

The difference between good and bad is all about what it can do for you. Once you know how to use debt to reach your financial goals, you can manage it to help build a better financial future.

Take the first step toward helping improve your credit health. Use our debt consolidation calculator to see how much you might save by consolidating higher-interest debt with a Discover personal loan.

¹ https://www.consumerfinance.gov/ask-cfpb/what-are-the-costs-and-fees-for-a-payday-loan-en-1589/

² https://www.consumerfinance.gov/ask-cfpb/i-heard-that-taking-out-a-payday-loan-can-help-rebuild-my-credit-or-improve-my-credit-score-is-this-true-en-1611/

³ https://www.consumerfinance.gov/ask-cfpb/what-is-credit-counseling-en-1451/

What is Good Debt vs. Bad Debt?

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