Is There Really Such a Thing as Good Debt vs. Bad Debt?

debt Mar 25, 2020

Let's face it. Debt can be complicated. In some cases, it's a necessary evil. And there are many ways you can go wrong with debt. I was like so many others who came out of school drowning in student loan debt. Couple that with credit cards and a car payment and I thought I would never get ahead. Believe it or not, though, debt can also be a good thing.  

Debt to Hurt You 

For many people, debt is a negative term, and it should be. There are many ways that debt can hurt your finances and can make it more difficult for you to secure your financial future. When you're looking at good debt vs. bad debt, you must look at the whole picture instead of just looking at the basics of "one kind" of debt. There are many different kinds of debt, and all of them can impact your credit in different ways. In fact, just having the debt exist isn't usually enough to make it hurt your credit, but the actions that you take can determine whether it's good or bad debt (more on that in a minute). 

Bad debt can be things like upside-down loans (meaning you owe more than it's worth- usually due to interest), having high-interest rates, having more debt than what you're worth (in most instances), and poor financial choices (payday loans).

Related post: Pay off Debt or Save for Retirement?

Negative Debt Actions 

Taking out a loan for something that you couldn't buy in cash is usually a negative debt action. In the case of auto and student loans as well as mortgages, this is sometimes unavoidable. Where many people go wrong is taking out more than they can afford. It can be easy to get caught up in thinking that since you are already taking out a loan that you may as well take out even more than what you needed. It is the difference in a $30,000 car and a $90,000 car when you're on a $45,000 per year salary. 

Other negative debt actions can include taking out high-interest emergency loans, only making the minimum on credit card payments, and spending more than what you can genuinely afford. It's essential to recognize that things like credit cards aren't inherently bad, but they can be "bad" debt when not used responsibly. Late payments and letting accounts go to collections are other very common negative debt actions that you might take.

What is good debt?

Possibly one of the best examples of good debt is a mortgage for a home that you can afford. Note: I'm only talking about a house that you can afford not a house that the bank will approve you for.

While the mortgage is likely the most significant loan that you'll take out in your lifetime, it can also be one of the most beneficial for your credit situation. As long as you take out a mortgage that you can afford, has a reasonable interest rate, and you practice good payment habits (paying on time, making extra payments when possible), your mortgage will usually work in your favor. 

Another example of good debt is a student loan that provides you with a lucrative career opportunity.  Keep in mind that this does not include all student loan debt.  Think about it as an investment and consider the return on the investment. 

Adding in several different types of credit (including mortgages, credit cards, and loans) can help improve your credit. Creditors want to see that you can handle a mix of different types of credit, and when you do, your credit score will go up! 

Positive Debt Actions 

When you take good debt and combine it with positive actions like paying it off, you'll be able to reap the benefits of a better credit situation. This can mean the difference in excellent interest rates and mediocre interest rates. It may not seem like much, but an interest rate of 1% is much different from an interest rate of 3% when you look at the extra amount of money you'll pay to borrow an initial amount. 

Paying your credit cards on time, sticking well below your credit limit, and keeping your debt to income ratio below 30% (or even 20%) can all help you practice good credit habits. The good news is that, in many instances, positive debt actions combined with good debt can make a huge difference in your debt situation. In fact, making just small changes can result in improvements to your credit score almost immediately.

Related post: 15 Best Budgeting Apps to Download

The Bottom Line 

Debt doesn't have to be a negative thing. While debt is inherently a "bad" mark on your finances, there are ways that you can make it work for you. Sticking to a budget, practicing good financial habits, and learning how to balance your good debt vs. bad debt can make a significant impact on your credit situation. Learn the right way to use your debt in your favor, and you'll be able to reap the benefits that come from having a good credit score! 

 

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