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Studies show that the average U.S. household carries over $137k in debt.
To me (and probably to you), that sounds like a lot of money. But not all debt is created equally — so what’s the deal with good debt vs. bad debt?
It’s all just money you borrowed and now have to pay back with interest, right?
Yes, that’s correct. But in the eyes of credit and financial institutions, there is a difference.
Good Debt vs. Bad Debt
Good debt is typically described as debt that has the potential to do something good for you in the future, like generate income or increase your earning potential. This type of debt usually falls on the lower end of the interest rate spectrum.
Bad debt, as you may have guessed, is just the opposite. It’s accompanied by higher interest rates, and the items it finances tend to lose their value fairly quickly.
Examples of Good Debt
Here are a few examples of debt that may result in long-term gains and are therefore considered less risky to creditors. They generally will not have a negative impact on your credit score (as long as you keep up with the payments).
Owning a home can be great – having a space all your own, no more roommates (with the exception of a spouse and/or munchkins), and not having to answer to a landlord are all major selling points of owning your own home.
What’s arguably even better than any of those things is that your home has the potential to increase in value (i.e. appreciate) over time, meaning you could eventually sell it for more than you paid for it. Of course, you’re also paying interest on the original amount, so you may or may not turn a profit in the long run.
On the flip side, you can own a home and have someone else pay the mortgage (i.e. rental property). While this is still a risk and a liability, at least according to Robert Kiyosaki of Rich Dad, Poor Dad , so long as you can fill it, your property has the potential to appreciate on someone else’s dime.
Potential to Generate Income = Good Debt
Similarly to mortgages, student loans typically have lower interest rates than other types of debt. And on top of that, the interest is tax-deductible.
College is said to be an investment in your future, and studies have shown that having a college degree can increase your earning potential by $1 million over the course of a lifetime. However, whether or not it should be considered “good” or “bad” debt should probably depend on how (or if) it’s used to do so.
Ability to Increase Earning Potential = Good Debt
Small Business Loans
Depending on the products or services offered, most small businesses require some degree of start-up capital. The idea, of course, is to borrow (or use your own) money to get your business off the ground, become profitable, and be able to pay off the initial investment relatively quickly.
Potential to Generate Income = Good Debt
Examples of Bad Debt
On the other side of the spectrum is bad debt. These type of loans are generally riskier, reflected by their higher interest rates, and can negatively impact your credit score if they get out of hand (i.e. maintaining a high credit card balance).
Sure, a vehicle is a valuable commodity, but whether you’re driving a 2017 Mercedes-Benz or a 2004 Saturn Ion, your vehicle typically will not appreciate in value. In fact, a new vehicle depreciates as much as 11 percent the moment it’s driven off the lot. Ouch.
Higher Interest Rate + Depreciates in Value = Bad Debt
Credit Card Debt
A credit card can be a useful tool if it’s used correctly.
However, credit card debt can get out of hand fast if it’s not properly monitored. Even those of us who consider ourselves relatively frugal tend to slip up from time to time if we’re not careful, which is why I recommend using a budget to stay on track.
Besides the slippery slope that comes with owning a credit card, they’re considered bad debt for another reason: 30 percent of your FICO Score is determined by amounts owed on your accounts, the biggest factor of which is your credit utilization ratio (balance/credit limit).
Therefore, carrying a high balance relative to your limit can significantly impact your credit score, and not in a good way.
High Interest Rate + Negative Impact on Credit Score (if it gets too high) = Bad Debt
Tip: If you don’t know your credit score, you should! Credit Sesame is the FREE tool I use to track and improve my credit score.
If you don’t know what a payday loan is, then good for you; may you never find yourself in a situation where you feel you must resort to one.
These are short-term loans with extremely high interest rates (like 300+ percent). The borrower typically writes a check for the loan amount plus a processing fee and gives it to the lender before borrowing money, agreeing to pay back the entire amount by their next paycheck.
If the borrower is unable to do so, they’re charged another outrageous “rollover” fee. Payday loans are a great way to turn a bad situation into a horrible one.
VERY High Interest Rate = Bad Debt
Is there really such a thing as good debt?
With a high correlation between debt and anxiety, how can we say that any debt is really “good”?
The answer, like so many other answers in person finance and in life, is: it depends on the person.
There are plenty of people in the world who are unphased by their debt. They know it’s there, they pay it off, and they know that one day it will be paid in full. But until then, they’re happy letting those payments run on autopilot.
These people are less debt averse, meaning they aren’t as bothered by their debt.
Some people, on the other hand, cringe at the thought of owing money for anything. Debt may cause them to experience severe anxiety or depression, and they may prefer to pay in cash rather than with loans or credit cards.
These individuals are more debt averse.
The way we approach our debt depends on which of the above categories we fall into, as well as our personal financial and life goals.
The good news is that if you’re in debt and want to get out, there is always a way. There are countless stories out there of people who have strapped on their boots and given debt a kick in the tush, and so can you.
To get started, check out 6 Easy Steps to Get Control of Your Money.
What kind of debt do you have and how are you paying it off? Are you more or less debt averse?
Let me know in the comments!
I’m a financial coach and author + owner of Goodbye to Broke. I love all things personal finance, money management, and healthy living. And I talk to my dog way too much, if we’re being honest.