Categories

Debt

Good Debt vs. Bad Debt: What’s the Difference?

"Neither a borrower nor a lender be" is among Shakespeare's most quoted lines, but the great playwright knew better than to follow that advice himself.

Unlike the debt-averse character who speaks those words, Shakespeare knew that borrowing is neither inherently good nor bad. As a boy watching his father dodge bill collectors, he learned the perils of excessive debt, but later in life, as a gentleman of means, he financed a series of real estate purchases that helped him retire comfortably.

In the 400 years since Shakespeare's era, it's still true that there are both good debts and bad ones. So what's the difference?

Good Debt vs. Bad Debt

Attributes of good debt include:

  • Reasonable expectation of lasting benefit from your purchase.
  • Repayment terms that are fair and affordable.

By contrast, bad debt can encompass:

  • Borrowing for purchases that don't have lasting value, or that become money-sinks.
  • Excessive debts that outpace your ability to keep up with payments.
  • Payment terms that bring financial hardship.

Lasting Benefit

Debt that provides lasting benefit can include:

  • Real estate investment. A mortgage loan that lets you purchase a home in a market with stable, steadily increasing property values is a type of debt that can have a long-lasting positive effect on your life. On a standard 30-year mortgage, as long as you maintain the property, you'll get the benefit of a dwelling for you and your family and have a good chance of selling it for considerably more than you paid when it's time to move on. Similarly, getting a mortgage on an income property (including a multi-unit building that can also serve as your own residence) can generate rental income you can use for retirement savings or other investments.
  • Business investment. A loan you use to start or expand a business can help generate an income stream that supports you and your family, and potentially creates an asset you can sell at a profit or pass on to family members when you decide to retire.
  • Personal investment. A student loan that helps educate you or a family member can be a type of good debt as well, if it equips the student with skills and experiences that allow them to repay their loan, increase their earning power or advance their life goals.
  • Car loans. With the possible exception of high-end collectible vehicles, cars are not investments. A brand-new car famously loses about 10% of its purchase price the moment you drive it off the lot; new cars can drop in value 25% or more in their first year; and virtually all cars decline in value as they age. But a car loan can still be a form of good debt if it helps you obtain reliable transportation that gets you to work and lets you live your life—and if the cost of maintaining, parking and running the car makes sense for you.

Purchases that don't and won't ever yield lasting return include most consumer goods, travel and leisure activities, fine dining, entertainment and the like. No one wants to eliminate these things altogether, but when fitting them into the grand scheme of things, it's wise to try to pay for them as you go, rather than funding them through debt.

It's important to note that no form of good debt is a sure bet, with an absolute guarantee of long-lasting value. Real estate values cycle up and down, businesses can suffer setbacks and even fail, and the earning capacity of a graduate can vary with their career choice and the state of the overall job market when they leave school. A car loan may make perfect sense (and be a practical necessity) if you commute to work in a rural or suburban setting, but residents of cities with high parking and fuel costs might be better off using public transportation or ride-sharing.

Payments You Can Afford

The cost of debt—how much you pay for the privilege of borrowing money—depends on a handful of factors, including:

  • The amount you borrow (which determines the size of your monthly payment)
  • The interest the lender charges for use of the money
  • Whether the loan takes the form of a revolving credit account (in which you borrow against a set spending limit and take as long as you like to repay the loan, as long as you make a nominal minimum payment each month) or an installment loan with fixed payments and a set repayment period.

When you seek out a loan, it's important to look long and hard at the size of your monthly payments. Simply being able to cover the required amount on an installment loan isn't all you should consider. Naturally you'll need to be sure you have enough left over for other fixed expenses (rent, groceries, utilities and so on), but you should also take care to maintain a household emergency fund and channel sufficient funds into retirement savings.

When it comes to revolving credit, your spending habits largely determine the size of the debt and the minimum monthly payment. Making only the minimum payment each month is an expensive choice because it means you incur steep interest charges that can pile up over time. And be aware that carrying balances in excess of about 30% of your borrowing limit can hurt your credit scores, potentially increasing the cost of future borrowing.

The Cost of Money

The interest rate you pay on your loan will largely be a function of your experience with credit and your history of repaying loans. When lenders consider your application for a loan or a credit card, they'll typically check your credit scores and credit reports to gauge your likelihood of paying back the loan.

If you're a seasoned credit user with a record of timely credit payments, you will have high credit scores. If you have little or no experience managing debt, or if your history of debt payment includes late or missed payments, that will be reflected in a relatively low credit scores. Lenders, using a system called risk-based pricing, typically offer their lowest interest rates to borrowers with good to exceptional credit scores, and charge higher rates to applicants with lower scores. If your score is too low, you may only qualify for pricey subprime loans; if it's lower still, your credit applications may be declined.

Loans to Avoid

The loans that often get people into the most serious trouble are those issued for relatively smaller amounts, from less conscientious lenders who charge extremely high interest rates. If at all possible, you'd do well to avoid these forms of debt:

  • Payday Loans. These loans are often issued in the amount of just a few hundred dollars, and typically require repayment within two weeks (in other words, when you get your next paycheck) and carry interest of $10 to $20 per $100 borrowed. This is the equivalent of an annual percentage rate (APR) well above 300%—more than 10 times the highest credit card APR. Borrowers who can't make their payments in full may find themselves forced to take out additional loans and getting stuck in a cycle of borrowing and repaying these extremely expensive debts.
  • Car title loans. Touted as providing cash fast, with no credit checks or proof of employment required, these loans require you to turn over your car title to the lender—effectively giving them ownership of the vehicle until you pay back the loan. You get to continue using the car, but if you fail to make payments, the lender can seize your car and sell it. These loans have had catastrophic consequences for cash-strapped borrowers who need their car for work, to transport kids to school, and so on.

Alternatives to Bad Debt

If you find yourself mired in bad debt, or if circumstances such as loss or reduction in income are threatening to make good debt less affordable, here are some options you might consider:

  • Debt consolidation. A debt consolidation loan can help you convert relatively costly credit card debt into manageable monthly installment payments. It can save you money over the long haul, but is most effective if you can avoid incurring additional credit card bills until you pay off the loan.
  • Credit counseling. A certified nonprofit credit counselor (in contrast to a for-profit "credit repair" company) can help you look at your debts, income and expenses, and formulate a plan to get matters under control. They can help you set up a budget and a timeline for getting your debts in hand. Depending on your circumstances, they also may recommend pursuing more drastic measures such as a debt management plan or, in severe cases, bankruptcy, which can relieve debt but which also seriously hurt your credit, and may limit your ability to borrow money for years to come.

Find the best personal loans in Experian CreditMatch.

May All Your Debts Be Good Ones

All debt comes with risk—for both lender and borrower, so it's important to do your homework and think ahead about both best- and worst-case repayment scenarios. If you're prudent and enter into debt with eyes open and a solid repayment plan in mind, all your debts can be good ones, and you can use credit to make a better life.

Resources