Good vs. Bad Debt: What You Should Know

Debt is a four-letter word that occasionally gets a bad rap.

Look around and you’ll discover that living with a little red ink on your personal ledger — especially if it’s the right kind — can sometimes prove financially beneficial.

Here’s your guide to understanding good and bad debt and leveraging it to your advantage.

What Is Debt?

In the most basic of terms, debt is an obligation that you owe to another person or entity after they loan you something of value. Usually, the thing borrowed and repaid is money.

Under formal debt arrangements like loans, lines of credit, and credit cards, you enter into a legally binding agreement to repay money you borrow, typically with interest, at a later date.

How Is Debt Used?

People usually take on debt to make purchases that cost more money than they have or are willing to spend from their personal nest egg.

For example, if you want to buy a home but don’t have several hundred thousand dollars set aside to pay for it, you can do what most people do: apply for a home loan (aka, a mortgage).

If you’re approved, a lender will give you the money you need to buy the house in exchange for you agreeing to repay the loan, plus interest, in a certain amount of time.

You can use debt in much the same way to finance other big-ticket items like a car or boat, or for smaller purchases that you can make with credit cards.

Living With Debt

Since the nation’s founding, debt has been part of the American way of life.

The United States began running up a national tab during and after the Revolutionary War and has continued to spend more than it brings in consistently ever since. In fact, the country has only been out of debt once in its history — in 1835.

Today, the federal debt stands at more than $28 trillion, while the total household debt for Americans now eclipses $15 trillion.

Looking ahead, there’s little doubt that individuals and the government alike will continue to borrow in order to pay for things they need (or want).

The key — both at the personal and political level — is to understand debt and use it wisely.

Understanding Different Types of Debt

Not all debt is created equal. However, it generally falls into four main categories:

Secured Debt

Secured debt requires you to put up collateral — an asset with tangible value that guarantees you’ll repay what you borrow.

Commonly used to finance large purchases or expenses over months or years, the most popular types of secured debt include:

• Mortgages
• Auto loans
• Home equity loans
• Home equity lines of credit (HELOCs)

If you’re consistently late or fail to make payments on your secured debt, the lender can sell your collateral and use the money from it to recoup some or all of what they loaned you.

Unsecured Debt

With unsecured debt, you don’t have to put up collateral in order to borrow. Instead, lenders use your credit score, income, and other factors to determine if they’re comfortable loaning you money.

Popular forms of unsecured debt include:

• Credit cards
• Personal loans
• Student loans
• Personal lines of credit

Generally, you can’t borrow as much money if the debt is unsecured. Lenders also charge higher interest rates since it’s harder for them to recover their investment if you don’t honor the terms of your agreement, which is known as defaulting.

Installment Debt

Installment debt refers to loans made in a lump sum and repaid in regular installments over a set period of time. Typically, you pay back what you borrow in equal monthly payments that include interest and a portion of the principal loan amount.

Depending on the size and type of loan, installment debt can be secured (think mortgages and auto loans) or unsecured (like personal loans and student loans). Either way, you know what you have to pay — and when — as long as you have the debt.

Revolving Debt

Revolving debt includes any type of loan that isn’t made for a set amount or period of time. The most common examples are unsecured credit cards and personal lines of credit.

With revolving debt, you’re approved for a certain credit limit that you can use or tap into whenever you like and repay in full or in part each month. Interest accrues at varying rates based on how much you borrow, the balances that you carry over from month to month, and the length of time you take to repay the debt.

Good Debt vs. Bad Debt: What’s the Difference?

Although not recognized as an official classification, there’s an additional — and arguably more practical — way to label debt: the good kind and the bad kind.

Good debt can be viewed as an investment that increases your net worth or enhances your life in a fundamental (or financial) way. Generally, this type of debt has lower interest rates and helps build credit.

Bad debt, as the term suggests, does nothing to improve your financial situation in the short or long term. It’s characterized by high interest rates and is frequently used for discretionary spending or to finance things that lose value quickly or over time.

Examples of Good Debt

For the most part, taking on (some) debt can be a good thing if you’re doing it for the following reasons.

Buying or Improving a Home

Few investments are as safe as real estate, so you can justify securing a mortgage to purchase a house or tapping into your home’s equity to make upgrades. As years go by and you consistently pay your mortgage, your equity and your net worth both increase.  

Paying for Education

Taking out a student loan to pay for college or technical school should be viewed for what it is: a long-term investment in yourself. You can reduce the amount you need to borrow by applying for scholarships, making the long-term ROI even greater.

Consolidating Debt

Borrowing money to settle other debt can sometimes be a shrewd move. That’s the case with debt consolidation, a financial strategy in which you use a personal loan to combine high-interest loans and credit card bills into a single, more manageable payment. 

Building Credit

You have to go into debt to build credit, right? Not necessarily, but that’s a common myth. Truth is, you can establish credit using a credit card wisely or by managing your finances creatively, either of which is a better alternative to burying yourself in debt.

Starting a Business

If being your own boss is the career path you’ve plotted, a personal loan or line of credit may help set your dream in motion. The key is to be realistic and develop a business plan that allows you to pay back debt as you become established and grow.

Examples of Bad Debt

On the flip side, borrowing is generally considered bad if your intent is to do any of the following:

Fill Your Closet

The concept applies to clothes, shoes, jewelry, or anything else that might trigger you to lay down plastic without considering the consequences. If it’s a want rather than a need and you don’t have cash to pay for it without stretching yourself thin, hit pause.

Feed Your Ego

Putting yourself thousands of dollars further in the red so you can drive a Corvette rather than a Camry — or pay for any type of status symbol — is not only shortsighted, it’s irresponsible. Leave pride out of the equation when making decisions about money.

Make Ends Meet

Relying on high-interest debt to simply get by can quickly spiral out of control. Loans and credit should be used within the framework of a well-planned personal budget rather than as a cornerstone of your household finances.

Live Beyond Your Means

Keeping up with the Joneses seldom yields contentment, particularly when you plunge yourself into debt doing it. If you have to max out your credit cards or take out a personal loan to pay for things you don’t need and can’t afford, you shouldn’t do it.

The Takeaway

Debt, in and of itself, doesn’t deserve all of the negative press it receives.  

When you utilize loans and various types of credit strategically, you can maintain financial stability and enjoy a healthy relationship with debt.

That’s the type of reputation management most anyone should appreciate.