Good debt versus bad debt: What to know and how to tell the difference.
Borrowing money is a fact of life for most adults, especially when it comes to paying for big ticket items like homes, cars, education or even starting a business. Having debt can be considered a good thing, since your credit score and credit reports are based on how well you manage it. And having a strong credit history can help you qualify for better borrowing terms and lower interest rates.
But some debts can be better than others — and whether the debt is considered “good” or “bad” can depend on several factors. “Before considering any type of borrowing solution, ask yourself if it’s going to help solve a need that you have,” says Becky Soetaert, Home Equity Product Manager, Commerce Bank. “It’s important to look at your income, expenses and budget, and know where your money is going each month, to determine if you can afford the debt,” she adds.
What is good debt and what is bad debt?
The primary difference between good debt and bad debt comes down to what you use it for and how you manage it. For instance, debt can be considered good if it helps you better manage your finances, like consolidating higher interest debt, or move forward with your goals, like improving your home or buying a car. Good debt is manageable — and you have a plan for repaying it.
Debt can be considered bad when your debt-to-income ratio is too high, the debt negatively impacts your credit history and you’re unable to repay it.
Examples of good debt and bad debt
Below are five common types of debt and situations where each type of borrowing solution could be either good or bad for your financial health.
1. Mortgage debt
Good for: Building equity as you make monthly mortgage payments and for purchasing an asset that will likely increase in value over time. You may enjoy low interest rates and possible tax advantages on this type of debt.
Watch out for: Borrowing more than you can comfortably manage and not paying attention to your mortgage terms, such as when the fixed rate period ends on an adjustable interest rate mortgage.
2. Home Equity Line of Credit (HELOC) or Home Equity Loan
Good for: Using your home’s equity to make improvements that help boost the value or enjoyment of your home, like finishing your basement or replacing a leaky roof. This type of debt may also have tax advantages when used for home improvements (see your tax advisor for details). Consolidating higher interest debt with a home equity account may save you hundreds of dollars each month, making it easier to manage your finances.
Watch out for: Borrowing too much and risking foreclosure if you can’t make the payments, since your home is used as collateral for this type of debt.
3. Student loan debt
Good for: Advancing your education to help achieve career goals and earn a higher salary. Student loans may have lower interest rates compared to other types of debt, and the interest may be tax deductible.
Watch out for: Borrowing more than you need. A recommended guideline is to limit borrowing to no more than you expect to earn as a starting salary when you finish school.
4. Auto loan debt
Good for: Managing essential transportation needs, like traveling to work or school. Auto loans generally have low interest rates for those with good credit.
Watch out for: Borrowing too much, or lengthy repayment terms that may result in you owing more than your car is worth.
5. Credit Card debt
Good for: Building a credit history by making payments on time. Credit cards can also be useful for financing a large purchase, like a major appliance, or for consolidating higher interest rate debt to help you better manage your finances. Some credit cards provide valuable financial perks like travel rewards, fraud protection and extended warranties on purchases.
Watch out for: Paying for lifestyle or non-essential expenses without paying the balance each month. Carrying a large balance with a high interest rate can lead to higher fees. Balances worth more than 30% of your available credit may negatively impact your credit score.
How to tell if you have too much debt
Having too much of any kind of debt can strain your budget and make it hard to save for future goals. Watch out for these red flags:
- A debt-to-income ratio of more than 43%. To determine your debt-to-income ratio, add up all of your recurring monthly debt expenses, then divide that total by your gross monthly income.
- Trouble making payments.
- You’re paying as much as you can, but your balances aren’t going down.
“Don’t hesitate to contact your lender if you’re having trouble making payments,” says Soetaert. “The sooner you reach out, the better it is for any impacts to your credit,” she adds. Your lender can help you explore repayment options, like revised loan terms or a refinance.
Factors to consider before borrowing
Soetaert encourages borrowers to review the terms of what they’re applying for in advance. “Read the fine print so you understand the repayment terms as well as any hidden fees. It’s also important to consider the total cost of the debt, not just the amount you’re borrowing,” she says. The total cost of the debt includes any interest you’ll pay as well as any fees.
Before you borrow, it’s a good idea to have a repayment plan in mind and consider how that plan fits into your overall budget. That can help you decide how much debt you can comfortably manage. It’s also a good idea to have an emergency fund to cover unexpected expenses and to try to limit new purchases as you’re paying down debt.
Understanding good debt versus bad debt, and managing any type of debt responsibly, can help you move forward with your financial goals. If you have questions about borrowing or would like more information, contact us.