Understanding Good Debt vs. Bad Debt

Many of us are taught to think of debt as something best avoided at all costs — and, if not avoided, paid off as quickly as possible. But as a matter of fact, not all debt is created equally — there's good and bad debt. The key to managing debt is to know the difference, as well as how to keep the two in balance with a sound debt management strategy.

What Is Good Debt?

In a nutshell, good debt enables you to buy lasting, important things that move you in a positive financial direction over time. Good debt is also "reasonably" priced — i.e., you're not borrowing from a loan shark. 

Good debt has collateral to help protect against default, such as a car or house. That's why good debt is more reasonably priced: Lenders are more comfortable lending to you — and generally charge less — when they have a tangible way to get their money back.

What Is Bad Debt?

Bad debt, in contrast, is borrowing to pay your routine living expenses without collateral, and paying a very high interest rate at that. Let's take a closer look at these two kinds of debt, and how to strike a balance between them.

Examples of Good Debt

The classic example of good debt is a home mortgage. Few people can afford to buy a home outright, without taking out a mortgage. But borrowers who put themselves on track to pay off their mortgage — rather than taking out new mortgages all the time as their home equity grows — generally have a sound debt management strategy. Homes also tend to increase in value over time, even if there are a few reversals along the way.

Often, a sound debt management strategy involves thinking ahead to retirement. Take the home mortgage example: When your mortgage is paid off, the cost of owning your home shrinks to property taxes, insurance and upkeep. That's helpful if your income drops in retirement. And when you no longer need the house, its value is available to you (or your heirs) — an advantage of taking on the debt to purchase it in the first place.

There's also the equity you build up in a mortgaged home, which is the difference between the value of the home and the amount you still owe on the mortgage. That equity can come in handy if you ever need to take out a home equity loan, which is a relatively inexpensive way of borrowing. And when you use a home equity loan to make home improvements, the interest is tax-deductible. (Keep in mind the laws governing the deductibility of home equity loans changed in 2018.¹)

Good debt doesn't necessarily have to finance something tangible like a house, however. For example, a college degree generally adds to your or a family member's earning power. Over the course of a career, the added earning power you may receive from attaining a college degree should more than offset the cost of that debt (the total interest you paid on it).

Examples of Bad Debt

Bad debt generally includes borrowing to pay for routine living expenses. It's a poor debt management strategy because with the added interest cost, you're paying more — possibly a lot more — than you otherwise would. This makes it much harder to build a solid financial foundation over time. Managing debt well requires living within your means.

Overusing credit cards is a common way many people rack up bad debt. This involves carrying a balance on your credit card account (or accounts) instead of paying the full balance at the end of the monthly billing cycle. Interest rates charged on card balances tend to be very high, because the debt is "unsecured." In other words, if you stop making payments, the credit card issuer has no collateral to take to sell and reclaim the funds owed. By contrast, a home mortgage, as noted above, is secured by the home itself, making the loan less risky for the lender.

Car loans are also secured (by the car), so the interest will be lower than on a credit card. Car loans can still be costly, because cars can get into accidents and tend to depreciate in value quickly. That makes the value of the collateral less secure, so the loan becomes riskier for the lender. Car loans generally fall somewhere between good and bad debt.

What's Your Debt-to-Income Ratio?

How much debt (both good and bad) is too much? One way to answer this question is to divide your total loan payments (including both the principal and interest amounts) by your pretax income. If, for instance, you're looking to take out a mortgage and the payment (along with any other loans you're making payments on) would exceed 42 percent of your pretax income, you'll generally be turned down.

But managing debt well usually means having a loan-to-income ratio well below 42 percent. Knowing how to manage debt also involves thinking about upcoming financial needs. For example, you may be able to get a good rate on a home equity loan to buy a boat, but if your children will be attending college in a few years and their tuition could be a stretch, that boat loan might not be such a good deal.

The Bottom Line

Think about managing debt within the context of your larger financial picture. For example, if your long-term goals include retirement, and taking out a new loan — whether a home mortgage or something else — will keep you from saving enough to retire on, that loan will probably come under the heading of bad debt. A sound debt management strategy is usually about keeping the bad debt to a minimum while keeping your long-term financial plans top-of-mind with every loan you consider.

Sources

1. Interest on Home Equity Loans Often Still Deductible Under New Law. https://www.irs.gov/newsroom/interest-on-home-equity-loans-often-still-deductible-under-new-law.