What's The Difference Between Good Debt & Bad Debt?

It doesn't always feel great to live with debt, so a lot of people come to believe that no debt at all is the best policy. And while having little or no debt in the long-term can help increase your odds of reaching financial independence, there may be times along the way when accessing debt is the smart move.

But not all debt is created equal. Some kinds of debt allow you to access opportunities that would otherwise be beyond your reach, while other kinds of debt just sort of ... drag you down. Today we're going to look at the differences between so-called "good debt" and "bad debt".

When you take on debt to improve your financial position, purchase assets likely to appreciate, or access skills and/or knowledge that can lead to better opportunities, it is generally considered a "good" use of debt. One of the most common examples is using debt to buy a house or income-generating property. Owning property has been a reliable way to build wealth over the long term since property tends to appreciate with time. Taking out a loan to buy a business is similarly considered a good use of debt: owning a profitable business improves your financial health (which is good for the lender, since good financial health makes you more able to manage the loan payments). Student loans are also generally considered "good debt", since you can (presumably) acquire skills & knowledge that allow you to earn more money, thus leading to greater financial stability.

"Bad debt", by contrast, is debt used to purchase depreciating assets like clothes, consumables, vacations, boats, and even automobiles. While some of those expenses can be considered necessary (you may need a car to get to work, for example), there is little chance of improving your financial health by using a credit card to pay for a vacation or a new television. That doesn't mean you shouldn't ever use "bad debt" – most people will use a loan to buy a car, for example – but it does mean that you should recognize that this kind of debt only results in money leaving your pocket.

A subcategory of bad debt is called "unsecured debt", which most commonly occurs when you use a credit card to pay for consumer goods or experiences. If you own a home (good debt) or a car (bad debt) and stop making payments, the lender can repossess the asset to recuperate some of the cost. This is called "secured debt" and, since the potential loss to the lender is limited, you can usually get secured loans at a reasonable interest rate. The same cannot be said for a large credit card balance from buying a fancy vacation or lots of nice clothes: there is nothing for the bank to take back, so this kind of debt is unsecured. Since lenders take on more risk with unsecured loans, they charge an arm and a leg in interest fees – hence why credit card interest rates are the highest you will likely ever be charged.

So how should you think about your own debt? First and foremost, always, always, always pay at least your minimum monthly fees. This will help keep your credit score up and, if you can keep spending in check, at least gives you a path to eventually repay all debts.

If you are in a position to pay more than your monthly minimums on all debt accounts, you should prioritize repaying the highest interest rate bad debt first. Since credit cards are unsecured debt and have super high interest rates, unpaid balances can grow exponential over time and become untenable. If your credit cards are paid off each month, then focus on the next highest interest rate debt – maybe an auto loan or student loan. Even though a lot of good debt comes with a high number attached (think mortgage), secured loans with favorable interest rates should come after credit cards, student loans, and auto loans in terms of repayment prioritization.

I hope this is helpful! If you have any questions, please sign up for weekly office hours to ask your question with zero pressure.

Thanks,

Timothy Iseler, CFP®

Founder & Lead Advisor

Iseler Financial, LLC | Durham NC | (919) 666-7604

Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.