Good Debt vs. Bad Debt
When you look at your bills each month, you may feel overwhelmed by the amount of money that you’re spending on debt. Sometimes debt might seem like a trap that you only want to fight your way out of, but not all debt is bad.
When a lender looks at your credit report to see what kinds of accounts you have, they'll look at some debts more favorably than others. If you’re focusing on getting out of debt, you first need to understand which debts are considered bad and which are considered good. That way, you can prioritize your debts so that you get rid of the bad ones first.
Which debt is good debt?
Some of your debt might be considered an investment. You’re probably thinking, “How can anything as bad as debt be considered an investment!” If you took on the debt to purchase something that will increase in value and can contribute to your overall financial health, then it’s possible that debt is a good one.
For example, a home purchase can be considered to be a good debt. Since homes usually appreciate in value, the mortgage loan you take out to pay for the home is an investment. Another example of a good debt is a student loan taken out to finance a college education. Earning a college degree usually means that you’ll make more money over your lifetime.
Which debt is bad debt?
When you use debt to finance things that can be consumed, you're taking on bad debt. This is the kind of debt that creates an unhealthy financial situation. Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never use debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, it should be intentional, e.g. for better financial management or to earn rewards, You should pay the balance in full each month.
Even debt used to finance a vacation is bad debt. Even though it might help you feel better and be more productive once you return, a vacation does not appreciate in value. Don’t use debt to pay for a vacation and especially don’t use it to pay for a vacation you can’t afford.
Making good choices about your debt
Good debt is obtained through making wise decisions about your future, not for the sole purpose of having good debt. For example, you might make the decision to obtain your Master’s degree to increase your earning potential. Taking out a student loan, if you have no other way of financing your education, is a valid reason for taking on additional debt.
Let’s say you’re analyzing your financial picture, trying to decide how to pay off your debts. It’s usually a good idea to focus on paying off your bad debts first. Since they provide no value, they're more costly than your good debts. You should pay off credit cards and auto loans before tackling mortgages or student loans.
Some people consider using good debt to pay off bad debt, like getting a mortgage for $110,000 instead of $100,000 and using the extra to pay off credit card balances. This isn’t a good idea for several reasons. First, repaying debt with debt is never a good idea. Second, it ends up taking longer to pay off the mortgage than it would have otherwise. Third, the higher mortgage increases your monthly payments and the time it takes to build equity in your home. Use cash to repay debts, not more debt.
You must still be careful that you don’t take on too much debt, even if it’s good debt. If you’re overloaded with debt, then it doesn’t matter whether the debt is good or bad, it still hurts your financial health.