Mar 26, 2024
Many people think that you should avoid any kind of debt. But not all debt is bad. Understanding good debt vs. bad debt may help you make smart choices about borrowing and reach important financial goals sooner.
In short, debt may be “good” when it helps you establish credit and build wealth. Debt may be considered “bad” if it’s costly, hurts your credit score, or makes it harder to reach your financial goals.
This article will help explain what good debt and bad debt mean, how to turn bad debt into good, and how to use debt to build a richer, more rewarding future.
“Good debt” refers to loans that help you reach your financial goals or improve your financial situation. These types of loans tend to have lower interest rates and help you increase your net worth.
Below are some examples of good debt:
Mortgages are often considered good debt because they make 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. Equity is the value of your home above what you still owe the lender. The equity in your home is part of your net worth. So as your equity grows, so does your net worth.
It’s important to know how much you’re able to 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.
Student loans are another kind of good debt. Although rates for student loans 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.
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 are too large or take too long to pay back.
To avoid that situation, 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 the rest of your financial situation. Also, paying more than the minimum amount due may help you pay back the loan sooner and save money on interest in the long run.
Interest on student loans might be tax deductible if you qualify, according to the Internal Revenue Service. 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.
Depending on where you live, you might need a car for everyday life or to get to work.
Depending on your financial situation, it may make sense to borrow money to buy a car. But you should be smart about it.
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 car 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.
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 buying equipment, hiring more staff, or increasing your marketing. It might also help your company build credit by allowing you to apply for loans in the future and continue to grow the business.
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.
Here are some examples of bad debt:
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 and are unable to pay at least your minimum monthly payment. This type of debt 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.
How might you deal with this type of debt? By 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 can 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.*
Also called cash advances, payday loans are among the most expensive kinds of debt you can have. These are short-term, high-interest loans for small amounts that you must pay back quickly—usually by your next payday. If you can, it may be best to avoid payday loans. They might not help with money problems and may even make things trickier.
For example, payday loans often charge 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.2 However, if you become delinquent on your loan, a collection agency might report that.
The good news is that it’s possible to change bad debt into good debt that helps you 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.
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 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.
Another solution may be a personal loan for debt consolidation. There are several benefits to a personal loan:
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
Defining debt as good or 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 improving 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.
Articles may contain information from third parties. The inclusion of such information does not imply an affiliation with the bank or bank sponsorship, endorsement, or verification regarding the third party or information.
*ABOUT SURVEY
All figures are from an online customer survey conducted September 14 to October 3, 2023. A total of 1,191 Discover personal loan customers were interviewed about their most recent Discover personal loan with 550 of them using the funds to consolidate debt. All results @ a 95% confidence level. Respondents opened their personal loan between January and July 2023 for the purpose of consolidating debt. Agree includes respondents who ‘Somewhat Agree’ and ‘Strongly Agree’.
