Your mom (and, OK, financial guru Suze Orman) is always waxing on about good debt versus bad. The truth: Every time those “payment due” notifications hit your inbox, it’s kind of hard to believe that any kind of debt can be considered good. Still—surprise, surprise—Momma was right. Here, a breakdown of the types of debt you can incur, and how they shake out on the good to not-so-good scale.
Wait, What’s the Difference Between Good Debt and Bad Debt?
Think of good debt as anything that has the potential to boost your personal wealth long-term. In other words: “Good debt pays for itself,” explains Priya Malani, founder of financial planning firm Stash Wealth. “It has a positive impact on your bottom line.” To help determine if a debt is good, it helps to ask yourself this: What’s the return on investment? Is this going to put money back in my wallet?
For example, a mortgage (versus rent that you pay in full every month) is good debt, since, in the long run, it will offset your housing costs and increase your overall net worth. Plus, real estate ideally increases in value over time.
An investment in education is also considered good because the rates tend to be low and the money you spend now is designed to help you make more money in the future. “Having a degree should allow you to earn significantly more, which overtime will more than pay for the cost of taking out the loans in the first place,” Malani says. (Of course, that’s assuming you graduate and continue to work and stay in the same job you had pre-MBA. “If you don’t, what could have been good debt quickly becomes bad,” Malani adds.)
More examples of good debt: A small business loan or investing in a company you believe in. Also, any debts that relate to your health (i.e., a necessary surgery or any cost that’s critical to keeping a loved one alive).
On the flip side, bad debt is tied to things that won’t eventually boost your wealth or don’t offer a financial return. “It’s pretty much anything that has a negative impact on your bottom line long-term,” Malani says.
In most cases, this means material possessions, paid for on a credit card (one of the worst types of debt). Also, personal loans. Why are these so bad? According to Malani, it’s twofold. “1) It often means you’re overspending and not living a lifestyle you can afford and 2) The APRs tend to be extremely high, which can cost thousands of dollars a year in interest and take many years to pay off.”
Short story: Anything that loses value or accrues fees is bad.
The Gray Area
Oddly enough, some debts can fall under both categories. For example, a car payment. It’s a bad debt since a car depreciates in value the second you drive it off the lot--and it can come with considerable fees, depending on the interest rate you secure.
But, unlike debt on your Mastercard, a car payment could also positively affect your credit score; if you make your payment in full every month, that helps you build up a positive credit history—never a bad thing.
Still, Malani adds: “No one should ever intentionally take on debt to boost their credit score. There are so many other, more financially sound ways to create and improve that number. For example, using a secured credit card to pay for daily expenses—like groceries—and paying off the balance on time and in full each month.”