Like many other things in life—technology, television, tiramisu—debt isn't inherently good or bad. But it can be beneficial or harmful depending on the circumstances. Debt's virtues, or lack thereof, depend on the purpose for which it is used and the manner in which it is issued and repaid. Here are some ways to identify good debt and avoid bad debt.
What Is Good Debt?
Good debt is the use of borrowed funds for purposes that provide lasting benefit, under fair repayment terms that are within your means and that you can reasonably expect to meet.
Types of Good Debt
- Mortgages: A mortgage that lets you finance a home in a location with stable property values is a type of debt that can have long-lasting benefits. A conventional 30-year fixed-rate mortgage with affordable payments can provide a home for you and your family and, if you maintain the property, there's a good chance you'll be able to sell it for more than you paid when the time comes. A mortgage on investment property (including a multi-unit building that can also serve as your home) can generate rental income you can use for retirement savings or other investments.
- Business loans: A loan you use to launch or expand a business can help generate income for you and your family and build an asset you can sell at a profit or pass on to family members when you retire.
- Student loans: A student loan that helps equip you or a family member with bankable knowledge and skills can help land a lucrative job or increase earning power, advance life goals and bring in the income to pay off the loan.
- Car loans: Cars tend to lose value over time so they're not a lifetime investment, but an auto loan can be good debt if it provides reliable transportation under terms you can afford, with enough funds left over each month to pay your other bills and to maintain and run the car.
What Is Bad Debt?
Bad debt is the use of borrowed money for purposes that don't yield long-term benefits or that exceed your ability to make regular payments each month.
Types of Bad Debt
- Unchecked credit card debt: Using credit cards for everyday payments is fine if they give you cash back, travel miles or other bonuses—and you avoid interest charges by paying your balance in full each month. Carrying large card balances over time is a recipe for trouble, however: Cards' variable interest rates may climb, and rising rates compound on your balances—meaning your debt can deepen and become unmanageable. If you're paying only your minimum required payment on growing card balances, you may be dealing with bad debt.
- Upside-down loans: If you financed a house or other asset when prices were at a peak, after which prices fell and are yet to recover, you may owe more on your loan than the value of the asset. This is known as being "underwater" or "upside-down" on a loan. Waiting out the down cycle may eventually put you back on solid footing, but an upside-down loan can be financially perilous if you want to borrow against (nonexistent or decreasing) home equity, or if circumstances such as a work-related move require you to sell the house.
- Payday loans: Often issued in amounts of a few hundred dollars and typically requiring repayment within two weeks, payday loans usually target borrowers who lack access to other forms of credit. They may charge $15 to $30 per $100 borrowed—equivalent to an annual percentage rate (APR) over 400%, or more than 10 times the highest credit card rate. Borrowers who can't make payments in full often end up borrowing additional funds and falling into cycles of debt and repayment of these costly loans.
- Car title loans: Promising fast cash without a credit check or proof of employment, title loans require you to turn over your car title to the lender—effectively giving them ownership of your vehicle until you pay back the loan. You can keep using the car, but if you don't make payments, the lender can seize and sell it. These loans can have dire consequences for borrowers who require a car for work, taking kids to school and other basic needs.
How to Get Out of Debt
If you're feeling overwhelmed with bad debt, or debt that once seemed good has become burdensome because your circumstances have changed, here are some guidelines for taking back control:
1. Target High-Cost Debt
When identifying debts to pay off first, look at those that are costing you the most each month. Often, these will be credit card accounts with the highest interest rates, but a high balance on an account with a lower rate could be a greater financial drain.
Look at the finance charges on each monthly statement and target the accounts with the biggest bite each month. Avoid making new charges and work at steadily reducing those balances. Opting for the debt avalanche or debt snowball payoff method can help you systematically tackle your debt.
2. Explore Debt Consolidation
If you're becoming overwhelmed by rising interest rates on large credit card balances, a debt consolidation strategy that lets you pay them off with funds you borrow at a lower interest rate could help you regain control of your finances. The most common forms of debt consolidation are debt consolidation loans and 0% introductory APR balance transfer credit cards, which both typically require good credit. Take care, however, to avoid running up high card balances again or taking out more loans once you've done so.
3. Consider Credit Counseling
Working with a certified nonprofit credit counselor (not a for-profit "credit repair" company) can help you identify the best way to get your debt under control. Credit counselors can advise on budgeting and debt management strategies and even set up a debt management plan where they negotiate with creditors on your behalf to help save you money and buy you time to pay off your debts.
4. Prioritize Essentials
A debt crisis can demand tough decisions, and may ultimately require changes in your living situation, transportation options and other lifestyle choices.
If, as you consider these options, you're forced to choose which debts to pay, focus on maintaining mortgage or rent payments to prevent housing insecurity. Try to keep up any auto loan payments if you rely on a car to get you to work—even as you consider finding less costly alternatives.
If you must limit your debt payments, try to make minimum payments on credit cards. And if you're unable to make some payments at all, reach out to your creditors proactively and explain your situation. You may be able to arrange temporary payment forbearance or restructure your loan terms.
5. Face Hard Decisions
If circumstances make it impossible for you to get out from under debt, you may need to consider last-resort options. Debt settlement, which lets you settle with creditors for less than you owe will hurt your credit scores for a time, and bankruptcy—which can free you from many debts altogether—will hurt your credit even more. While these drastic measures are hard to face, they can relieve you from the worry of overwhelming debt, and eventually you and your credit can recover and move on.
Best Bets for Good Debt
Anytime you take on debt, it's important to do your homework and think through best- and worst-case scenarios for repaying your obligations. If you keep your eyes open and maintain a solid repayment plan, credit can help improve your life and all your debts can be good ones. If you find yourself falling behind and debt consolidation looks like a good option for you, consider Experian's free CreditMatch™ tool for finding a loan that meets your needs.