What is Good Debt vs. Bad Debt?

Good debt is borrowed money that will advance your financial position in time, often helping you create and build long-term wealth. Good debt often has lower interest rates than bad debt and may have more favorable loan terms. Examples of good debt may include:

• Mortgages: You can take out a mortgage to acquire real estate that you can sell later or rent out to generate monthly cash flow.
• Small business loans: You may leverage a small business loan to purchase an existing business, which can supplement your primary income stream.
• Student loans: You can use student loans to pay for an education, which can eventually lead to a higher-paying job.

The key distinguishing factor of bad debt is that it's financing that negatively impacts your financial situation. Examples of bad debt can include:

• Credit cards: While credit cards can help build your credit score with responsible management, they can quickly become bad debt if you purchase items you can’t afford to pay off.
  
  If you do not pay off your balance in full each month, you’ll accrue interest. This is an additional expense that you must pay to the credit card company on top of the amount you borrowed. Further, by only paying the minimum amount owed each month, you'll continue to accumulate interest, making it more difficult to pay off the credit card.
• High-interest consumer loans: These include payday loans, title loans, or other predatory loans with high rates, which can make it difficult for borrowers to pay back the financing.

Here's a quick comparison to help you further distinguish between good debt and bad debt.

Bad debt poorly managed can put you in a cycle of debt where interest begins to spiral.

• Assess and classify your debts: If you don’t know exactly how much you owe and how much it’s costing you each month, getting out of bad debt can feel insurmountable. The first step to clearing a debt is to get a snapshot of your current debt burden, including which lenders you owe money to, the total amount due, the monthly minimum balance, and the interest rate.
• Choose a debt repayment strategy: Two of the most popular repayment options are the debt snowball and the debt avalanche. With the debt snowball, you aggressively pay off the smallest balance debt first while meeting minimum payments on other debts. This approach helps build confidence. The debt avalanche starts with tackling the highest interest debt first, regardless of amount, to create the most savings over time.
• Be prepared to make sacrifices: Sticking to an aggressive debt repayment plan often means making trade-offs. Instead of taking a vacation this summer, you might instead need to put money toward paying off the credit card from the last trip. If you’re committed to your repayment strategy, the sacrifice will likely be worth it to free yourself from bad debt.
• Consider debt consolidation: A  debt consolidation loan helps streamline debt repayment by combining all debts into a single monthly payment with a fixed interest rate. If you have a lot of credit card debt or other high-interest debt, debt consolidation loans are personal loans that tend to have lower interest rates and may save you a lot of money over time.

Is borrowing money good or bad?

Borrowing money is neither inherently good nor bad; it depends on how and why you use it. Borrowing can be good if it’s used for investments that enhance your financial situation, such as purchasing a home, funding education, or acquiring a business. It becomes bad when it’s used to finance unnecessary or impulsive expenses, leading to high-interest debt and financial strain. The key is to manage borrowed funds responsibly and ensure they contribute to your long-term financial goals.

Is a car loan good or bad debt?

A car loan can be considered good debt if it helps you purchase a reliable vehicle that supports your personal or professional needs and if the loan has favorable terms. It becomes bad debt if it leads to financial strain due to high-interest rates or if the car’s value depreciates faster than the loan balance.

How can good debt turn into bad debt?

Good debt can turn into bad debt if it becomes unmanageable due to changes in your financial situation or poor handling. For example, a mortgage on a home can become bad debt if you struggle with payments due to job loss or excessive borrowing. Similarly, student loans used for education can turn into bad debt if they lead to financial distress or if the education doesn’t result in better earning potential.