Good Debt vs. Bad Debt: Know the Difference

Debt is often perceived as bad, unhealthy and detrimental for our financial health. Debt plays an important role in maintaining financial wellness, but not all debt is inherently “bad.” Some types of debt can actually be considered good.

What is "good" debt?

Good or healthy debt is any kind of investment that will grow in value or provide long-term income. A mortgage, whether for a home or a business, could be considered healthy debt. Student loans can also be seen as good debt if they help you gain a job with higher income. Similarly, small-business loans can be deemed healthy debt if they lead to income production.

Interest rates are usually lower and terms are typically more favorable for loans that might be considered healthy debt. They can sometimes offer tax advantages, too.

A home equity loan can be beneficial for improving your home. Low rates make it even more attractive, as it adds value to your property.

But even with “good” debt, it’s important to make sound choices depending on your financial situation. For instance, buying a home outside of your budget can make you house-poor. Taking out student loans to pursue a degree you don't use or even finish can result in debt with no value. With intentional financial planning, taking on "good" debt can lead to a sense of financial peace.

What is "bad" debt?

Types of "bad" debt is typically used for things you want and not necessarily what you need. Additionally, it often comes with a higher interest rate.

Credit card purchases, payday loans, cash advance loans and other high-interest loans are some examples. These can be even more detrimental if you let it accumulate. That in turn can be harmful, luring you into a debt trap you have a hard time escaping.

Are there other kinds of debt?

Some types of debt fall into a gray area – not necessarily good or bad. This includes debt such as vehicle loans, 401(k) loans, debt consolidation and medical debt.

A vehicle depreciates in value, but it might be necessary to get to work or do your job. Several factors may affect whether a vehicle loan may be good or bad. These include the vehicle you buy, how your debt is structured and your ability to pay it off on time. Car loans with especially high interest rates or out of your monthly budget would be considered bad debt.

A 401(k) loan is better for your financial health than taking out a high-interest loan. However, if you don’t pay it off within 5 years, it becomes taxable income. Additionally, consider if the loan is used for a want versus a need. These different factors would put your into either good or bad debt.

Debt consolidation can be healthy if you’re able to find more favorable terms – such as through a home equity loan. But you also have to change the habits that lead to the debt. Sometimes people think of debt consolidation as “clearing the slate,” and they end up taking on more debt. If possible, avoid using debt to pay off debt, and instead try to earn more money and cut back on your spending.

Medical debt also falls into a gray area. It’s often unavoidable, but even if you’re on an interest-free payment plan, it doesn’t benefit you financially. When applying for jobs, make sure you consider benefits as well as salary. With rising healthcare costs, it’s especially important to pay attention to an employer’s health insurance plan.