Feb 02, 2024
Many people think that you should avoid any kind of debt. But not all debt is bad. Debt may be “good” when it helps you establish credit and build wealth. Debt can be considered “bad” if it’s costly, hurts your credit score, or makes it harder to reach your financial goals.
Knowing the difference between good and bad debt can help you make smart choices about borrowing and reach important financial goals sooner.
This article will explain what good debt and bad debt mean, how you can change bad debt into good, and how to use debt to build a richer, more rewarding future.
“Good debt” refers to loans that help you reach your financial goals or improve your financial situation. These types of loans tend to have lower interest rates and help you increase your net worth.
Below are some examples of good debt:
Mortgages
Mortgages can be considered good debt because they make home ownership affordable and may help you improve your net worth.
A mortgage is secured using your house or other real estate property as collateral. Purchase mortgages make it possible for you to buy a new home. Second mortgages, such as home equity loans, let you borrow from the difference between the current market value of your home and an existing mortgage.
When you purchase a home with the help of a mortgage that fits in your budget, you can build home equity over time. Equity is the value of your home above what you still owe on your mortgage. The equity in your home is part of your net worth. So as your equity grows, so does your net worth.
Mortgages typically have high borrowing limits. It’s important to know how much you can afford before you apply. Look for a mortgage with a reasonable interest rate and repayment term and make sure the monthly payments fit into your budget so that you can maintain on-time payments.
Student loans
Student loans are another kind of good debt. Although rates for student loans have gone up recently, they are still lower than many other types of debt. Moreover, you can use them to get a degree that could advance your career.
Degrees can also help you increase your income as you earn promotions and raises. College graduates tend to earn more than workers who have only a high school diploma, according to the Bureau of Labor and Statistics. But student loans can also be a burden if they are too large or take too long to pay back.
To avoid that situation, try to borrow less to pay for your education than what you expect to earn in your first year on the job. For example, if your starting salary your first year out of school will be $60,000, limit your borrowing to $60,000.
That way you should be able to pay back the loans within a 10- to 15-year period. Even better, pay more than the minimum amount due as often as you can. You will pay back the loan sooner and save money on interest in the long run.
Interest on student loans might be tax deductible if you qualify, according to the U.S. Department of Education. If you have multiple loans, consider combining them into a student loan consolidation. You might be able to lower your interest rate, shrink your monthly payments, and simplify your finances with one monthly loan payment. But remember: If you extend the repayment term, you could end up paying more in interest.
Car loans
Depending on where you live, you might need a car for everyday life or to get to work.
Sometimes it makes sense to borrow money to buy a car. But you can be smart about it.
Choose a car that is reliable and affordable rather than the latest, decked out model so that you can find a repayment term and monthly payments that fit your budget.
Make sure you’re getting an affordable interest rate on your car loan and choose the shortest repayment term possible for your budget. Although a longer repayment term can lower your monthly payments, you will end up paying more in interest overall.
Business loan
A low-interest-rate loan to help you launch a business can be well worth the expense if it allows you to pursue a passion and build wealth for yourself and your family.
A business loan can help you take your business to the next level. You can use it to pay for things that will increase the value of the business, like a new-product launch or hiring more staff. It can also help your company build credit so you can apply for loans in the future and continue to grow the business.
“Good” debt helps you increase your net worth or earning potential.
“Bad debt” refers to loans with higher interest rates and fees that prevent you from making progress toward your financial goals. This kind of debt can feel like a burden and leave you feeling overwhelmed. Too much debt can damage your credit score and make it difficult to access credit when you need it.
Here are some examples of bad debt:
Higher-interest credit cards
There is nothing bad about using credit cards. In fact, using a credit card for purchases you can afford and paying at least the required minimum payment or up to the full balance each month may help you build credit and improve your credit score.
But credit card debt can turn into bad debt if you overspend and are unable to pay at least your minimum monthly payment. This type of debt may harm your credit score and make it difficult to get credit in the future.
The Federal Reserve reports that 45% of all U.S. families owe credit card debt, with the average amount owed being $6,270.
What’s more, the interest rate on credit cards can be high (sometimes with an APR of 20% or higher), which makes repayment expensive. (For comparison, personal loan interest rates averaged 10.82% as of April 2023.1)
How can you deal with this type of bad debt? By making a plan for paying it off. One effective way to do this is by consolidating your higher-interest credit card balances into one personal loan with a lower interest rate.
That can make your debt more manageable and help you pay it off faster, bringing you closer to your goal of being debt-free. In fact, 85% of surveyed customers told us taking out a Discover® personal loan for debt consolidation helped improve their financial future.*
Payday loans
Also called cash advances, payday loans are among the most expensive kinds of debt you can have. These are short-term, high-interest loans for small amounts that you must pay back quickly—usually by your next payday. Unless you have no other choice, try to avoid payday loans because they could make your money problems worse.
Payday loans can have APRs as high as 400%, according to the Consumer Finance Protection Bureau. This is expensive money to borrow and can lead to even greater financial struggles. Just how expensive are payday loans? Consider this: Over the course of the year, a borrower may spend more than $1,500 in interest to pay back a $500 payday loan with a 300% APR.
Also, even if you pay back the loan on time, it won’t help your credit score. That’s because payday loans generally aren’t reported to the credit bureaus.2 On the other hand, if you become delinquent on your loan, a collection agency might report it.
The good news is that you can change bad debt into debt that helps you make progress toward your financial goals. The first step is getting a clear picture of what you owe to each lender. Then you can decide the best way to wipe out those debts.
Balance transfer card
One option is a balance transfer credit card. These cards let you transfer the balance of one card to another with a zero-interest introductory period. Just remember: Once the interest-free period ends, you will be charged the standard interest rate on whatever balance is left.
Balance transfers could be good short-term solutions for smaller debts—if you can pay off the balance within the zero-interest period.
Debt consolidation loan
A better long-term solution may be a personal loan for debt consolidation. There are several benefits to a personal loan:
Credit counseling
If you’re struggling to keep up with higher-interest debt and need help sorting through your options, you may think about working with a credit counselor. A credit counselor is a trained professional who can give you expert guidance on how to budget, negotiate with creditors, and create a debt management plan. The first session is usually free. There are organizations like the Consumer Protection Financial Bureau that can help you find an accredited credit counseling agency.
Defining debt as good or bad is all about what it can do for you. Is your debt working for you or holding you back? Once you know how debt can help you succeed, you can make it a healthy, productive part of your life and use it to build a better financial future.
Take the first step toward improving your credit health. Use our debt consolidation calculator to see how much you could save by consolidating higher-interest debt with a Discover personal loan.
Articles may contain information from third parties. The inclusion of such information does not imply an affiliation with the bank or bank sponsorship, endorsement, or verification regarding the third party or information.
*ABOUT SURVEY
All figures are from an online customer survey conducted September 14 to October 3, 2023. A total of 1,191 Discover personal loan customers were interviewed about their most recent Discover personal loan with 550 of them using the funds to consolidate debt. All results @ a 95% confidence level. Respondents opened their personal loan between January and July 2023 for the purpose of consolidating debt. Agree includes respondents who ‘Somewhat Agree’ and ‘Strongly Agree’.
