What Is the Difference Between Good and Bad Debt?

For many, debt is an unavoidable part of the personal finance experience. There are many different types of debt, however, with important distinctions between debts which help you reach your goals and those that will sink your fortunes. So, how can you tell the difference between good and bad debt?

What Is Good Debt Versus Bad Debt?

The best way to understand good versus bad debt is by determining whether it supports your long-term objectives.

Good debt can help you reach your goals. Home ownership, advanced education, and driving reliable vehicles can all be worthy ambitions that will often require taking on debt to achieve. Borrowing funds in pursuit of these goals can be considered good debt, as they can help you to purchase a house, fulfill your professional aspirations, or safely transport you and your family from place to place.

Bad debt, on the other hand, is borrowing money in order to purchase an item that is more fleeting in nature. Splurging on a new outfit, an outlandish vacation, or another discretionary purchase can set back your finances without helping you reach any longer term objective. Bad debt is often consumer debt, which occurs when you use your credit card to purchase non-essential goods that you simply cannot afford.

When Good Debt Turns Bad

The organizing principle of good debts is that they will propel you towards a stronger financial standing in the future. However, this is not always the case.

Not every good debt that you take will turn out to be a worthwhile decision. This could be for a multitude of reasons, ranging from decreasing house prices to educational setbacks to absorbing too many obligations.

For instance, you could find your home loan underwater, meaning that the balance you owe on your mortgage is worth less than the value of the home. When the housing market tanked due to the 2007-2008 Great Recession, many homeowners suddenly discovered that their houses were not worth nearly as much as they had paid for them. While was not an acute concern for those staying put for the long haul, this changed the calculus for those who had been planning on selling.

Similarly, taking on school loans can be a necessary cost of getting your degree. However, if you do not graduate or your job prospects are not so promising, you can find yourself with a mountain of debt that could take years to escape from.

There are unexpected potholes on the road of life that influence our decisions, and your situation could change for any number of reasons. That being said, taking the time to truly consider your purchases can allow you to understand which ones align with your long-term goals. This can often help you avoid taking on financing that you will later come to regret.

Being Intentional With Your Finances

The best way to circumvent the trap of bad debt is to avoid taking on debt in the first place. While this is not practical advice for many, there are a number of steps you can implement to minimize your prospects of finding yourself in the debt trap.

When it comes to good debts like mortgages and educational expenses, confirm that you have a feasible plan to repay your obligations. This includes looking at the overall cost of the loan, and whether your current or future finances will allow you to repay the debt back in full and on time. (You can use TipRanks’ mortgage calculator and student loan calculator tools to understand the overall cost of any prospective loan you are considering.)

In order to avoid taking on bad debt, make sure that you have the means to afford any non-essential purchases. Building a budget is a great way to be intentional with your finances, confirming that your spending choices are consistent with your means. Creating an emergency fund can help you to avoid going into credit card debt due to unforeseen expenses, such as medical bills or home repair costs.

Conclusion: How to Consider Financing

There is nothing inherently wrong with borrowing money, especially if doing so will help you to reach your objectives in life. However, taking on debt is an obligation, one that you will need to repay.

Good debts are those that will help you realize your ambitions. Bad debts are ones that do not fit with your overall goals.

It is therefore incumbent upon you to consider whether the financing is the best way for you to realize your goals. For instance, there might be cheaper educational and transportation alternatives that require less or no financing which could serve as better options.

The best kind of debt, of course, is the one that you have already repaid. In addition to making sure that the loan fits with your long-term aspirations, it is just as important that you design a realistic pathway to fully repay the debts that you might accrue along the way.

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