Becoming debt-free is a worthwhile goal to have, but not all debt is bad and should be avoided in the first place. Depending on how you use debt, you could leverage it to improve your financial situation.
At the same time, though, even some good debts could become bad debts if you take them on unnecessarily or irresponsibly. Here’s what you need to know about good debt vs. bad debt and how to create a strategy to eliminate them.
What is Good Debt?
Good debts are designed to help you improve your financial situation or have some kind of tax benefits attached to them. In general, here are a few that are considered good:
While the student loan debt crisis continues to make it difficult for college graduates to manage their finances effectively, student loans are generally considered good debt for two reasons.
The first is that interest rates are relatively low — for the 2018-2019 school year, federal loan rates are 5.05% for undergraduate students and start at 6.6% for graduate and professional students.
Second, the student loan interest deduction allows many student loan borrowers to deduct up to $2,500 in interest paid on eligible student loans from their income each year, even if their loans aren’t itemized.
Buying a home isn’t for everyone, but if it makes sense for your situation and you can afford it, a mortgage is typically considered good debt.
That’s because mortgage loans typically come with low interest rates — rates can change daily, but in February 2019, a 30-year fixed rate hovered around 4.375%, according to Wells Fargo.
Also, the IRS allows most people to deduct interest paid on a mortgage worth up to $750,000 as an itemized deduction on their tax return.
Home Equity Loans
In the past, all interest paid on a home equity loan or line of credit was deductible on your tax return. But with the Tax Cuts and Jobs Act, that benefit was devalued.
Now, that interest is deductible only if you use the debt to buy, build, or substantially improve the home you’re using as collateral.
That said, even if you get a home equity loan or line of credit for some other reason, it can still be considered good debt because they typically come with low variable or fixed interest rates.
Small Business Loans
It’s not easy to build a business without outside funding, and borrowing money is an excellent alternative to seeking investors. Not only does it allow you to maintain complete control of your business, but it also helps you maintain your equity in the company.
While some business loans from commercial banks, especially loans insured by the U.S. Small Business Administration, can have low interest rates, online lenders typically charge more. As a result, it’s important to shop around.
What is Bad Debt?
Unlike good debt, bad debt includes high-interest and avoidable credit that can threaten your financial security even in small amounts. Here are some bad debts to watch out for:
The average credit card interest rate is 16.86%, according to the Federal Reserve, but many cards charge rates upwards of 20%.
Cost alone isn’t what makes credit card debt so threatening, though. Credit cards are a form of revolving credit, which means that there’s no set repayment period. Instead, credit card issuers typically ask for a minimum payment of 1% to 2% of your balance each month, making it easy to rack up a huge balance over time with no end in sight.
Personal Loans Spent Frivolously
You can use a personal loan for just about anything, but that doesn’t mean you should. The Federal Reserve pegs the average interest rate on a two-year personal loan at 10.70%. But if your credit isn’t in great shape, you could end up with a rate of 30% or more.
As a result, using a personal loan to finance a vacation or another large purchase could put you in a difficult spot financially. In general, it’s better to save for those expenses.
It’s possible to get a 401(k) loan at a decent interest rate, but that’s not what makes this type of debt a bad one. Not only does a 401(k) loan cause you to miss out on potential investment growth, but losing your job could cause you to default.
That’s because 401(k) loan providers typically require you to repay a plan loan in full within 60 days of termination, regardless of your original terms. According to the National Bureau of Economic Research, 86% of borrowers who leave an employer with an outstanding 401(k) loan end up defaulting.
If you default, the loan would be treated as an early withdrawal subject to income taxes plus a 10% penalty. So even if you score a low interest rate, the stakes can be high.
Payday Loans or Cash Advance Loans
Payday loans are often considered a last-resort option for people with bad credit. But payday lenders are considered predatory for a reason. A typical payday or cash advance loan comes with an APR of 400% or more and a repayment term of 14 days.
This high-cost, short-turnaround situation makes it difficult for most borrowers to pay back what they owe on time.
In fact, the Consumer Financial Protection Bureau found that 80% of payday loans were rolled over or reborrowed within 30 days — and 20% of payday borrowers ended up defaulting.
If you’re not careful, you could end up in a vicious cycle of debt from payday loans, taking out multiple loans to cover the compounding fees and interest without ever paying off the principal.
Easy Ways To Determine If Debt Is “Good” or “Bad”
- Good debt generally applies to investments that have the potential to increase your net worth.
- Bad debt generally applies to money you’ve borrowed to pay for assets that depreciate over time.
- Not all debts can clearly be defined as good or bad. Sometimes it depends on your individual financial situation.
Can Good Debt Turn Into Bad Debt?
How you use debt is just as important as its type, if not more so. For example, a mortgage is typically considered good debt. But if your mortgage payment is so high that you end up house-rich and cash-poor, that debt is toxic to your financial wellness.
The same goes for any other type of good debt. Student loans, for instance, can help you afford a college education. But if you’re not careful about how much you borrow and aren’t looking for other ways to limit your debt burden, it can make life difficult when you graduate.
Regardless of the type of debt you have, it’s important to use it wisely and responsibly to maintain financial security.
Are Car Loans Good Debt or Bad Debt?
Car loans can be a gray area depending on your situation. If you absolutely need a new car and have good enough credit to qualify for a low interest rate, a reasonable car payment can get you what you need without negatively impacting your cash flow.
But if you buy a more expensive car than you need or have bad credit, a car loan could potentially make life difficult.
Are Consolidation Loans Good Debt or Bad Debt?
This is another gray area that depends on your circumstances. When used properly, a consolidation loan can help you pay down higher-interest debt more quickly, especially credit cards.
But if the payment on the new loan is unaffordable or the interest rate is higher than what you were paying before, you’ll have less flexibility and can end up in just as much trouble as you were in the first place, if not more.
Is Borrowing a Loan to Invest a Good Idea?
It’s not uncommon for experienced investors to borrow money to invest. Most brokerage firms offer what’s called margin accounts, which allows you to borrow at a fixed rate to increase your stake in a stock or other form of security.
But trading on margin only makes sense when the potential for a return is higher than the interest rate the broker charges. Because measuring risk in the stock market isn’t easy, using this type of debt isn’t a good idea for most people.
Guidance for Paying Off Debts
If you want to eliminate your debt, it’s important to know where to start. Understanding good debt vs. bad debt can help you do so.
Here are a few tips to help you get rid of your debt in the most effective way possible:
- Keep tabs on your debt and interest rates. Knowing where you stand with your debt is half the battle. Ignoring it is a surefire way to make things worse.
- Prioritize an order to pay off debts. While some experts recommend starting with the highest interest rate first, others suggest tackling the debts with the lowest balance to give you some wins early on. Choose the option that works best for you.
- Consider refinancing options. Most loan types allow you to refinance your debt at a lower interest rate based on your creditworthiness. If your credit has improved since you first took out a loan, consider refinancing it to lower your rate, payment, or both.
- Pull back on discretionary spending. The more you can put toward paying off your debts each month, the faster you’ll achieve your goal. Take a look at your budget and find areas where you can cut back for a while. It may not be comfortable, but it can save both interest and time.
As you work on paying down your debt, remind yourself why you want to be debt-free and stay focused. It can take years to achieve your goal, but the effort will be worth it.