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Understanding Bad Debt vs. Good Debt and Why It Matters

When it comes to your personal finances, not all debt is equal. Some debt helps build your credit history; other debt can be less desirable in the eyes of credit rating agencies. In fact, the differences between “good” and “bad” debt can be more nuanced than you might expect.

At the time you acquired it, your higher-interest debt may have made sense. But if your finances have changed, and you’ve fallen behind in your payments, that debt may go “bad.” Or maybe you took out a higher-interest loan during a crisis when you had limited options. You may have the option to convert these obligations into a financially healthier debt scenario if you’re back on your feet.

The good news about “bad debt”? You can get back on track, take control of your finances and even use loan products to improve your credit health.

This article aims to help you understand what constitutes good debt and how to best use it to enhance your financial life. From there, you can create a strategy for reducing your higher-interest debts and put yourself back on a healthy financial track.

Understanding good debt

First, it’s important to know that certain debt can be “good.” Good debt generally refers to loans or credit tools that help you achieve financial goals or improve your financial health. A mortgage offers a good example. If you borrow money to buy a home that’s within your means and you can afford the monthly payments, then that debt can help you build your net worth.

Student loans can also often be considered good debt. That’s because they may be low-interest, can help advance your career goals and ultimately boost your earning power. Student loans can help put you on the path to a brighter financial future.

The big takeaway: Evaluating debt is about context. You want to ensure that with any loan or credit product, you can make at least the minimum payment — and even a bit more — each month. That way your debt can become a healthy, responsible part of your financial picture and not a potential ding to your credit score or worse.

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Understanding bad debt

If good debt helps you improve your financial circumstances or facilitates purchases that work within your means, then what is bad debt? In general, debt is bad if it imperils your financial health. Bad debt often has higher or variable interest rates, which may increase over time.

For example, short-term or payday loans often charge exceptionally high interest rates. A borrower may spend more than $1,500 in interest to pay back a $500 payday loan over the course of a year. It’s expensive money to borrow and can lead to additional financial struggles.

Variable rates mean that your required payment can change every month, making it difficult to budget for loan payments. Debt can also become a problem if you’re using it to make purchases that are far beyond your financial means or lose their value immediately.

Finally, as noted above, debt that begins with good intentions can also become problematic. You may take out student loans to fund a degree that improves your career prospects, for example. But if the amount you owe ends up exceeding what you can afford with your post-grad salary and other obligations, then that debt may make it more difficult to achieve your other financial goals.

The takeaway: Debt isn’t objectively good or bad. You have to consider your ability to pay the debt back and how that process impacts the rest of your financial life.

Improving your credit health

Fortunately, you can transform higher-interest debt into manageable debt. The first step is to get your arms around what you owe to which lender.

Once you have a good sense of the scope of your debt, investigate consolidating it under one loan. In so doing, you can often reduce your overall interest rate (the consolidated loan rate may be less than the various interest rates you were paying). Reducing your interest rate alone can save you money.

Importantly, a debt consolidation loan also simplifies the repayment process, making it easier to pay down your debt and move on. You end up with one monthly payment instead of multiple payments. Since a personal loan gives you fixed rates and flexible terms, you can budget for a set, regular payment and know exactly when you’ll have the debt paid down. Note that often you cannot consolidate secured or student debt into a personal loan.

Debt is an important part of a responsible financial life. When you learn to navigate what makes sense for your budget and your goals, you can work to keep all of your debt in the “good for you” category.

Take the first step toward improving your credit health. Use our debt consolidation calculator to see how much you could potentially save by consolidating higher interest debt with a loan from Discover. Estimate Savings