Good v. Bad Debt: What's the Difference?

Except when it’s not. 

Sometimes, it’s smart to take on debt. In fact, there are times when we don’t have any choice. Let’s take a closer look at debt — the good, the bad, and how to tell the difference. 

Student loans 

Borrowing money to finance a college education is a prime example of good debt. It’s not about buying a product that will depreciate, it’s about making an investment, one that will pay itself off, hopefully, many times over. 

And there are numbers to back it up. 

The difference in lifetime earnings between college and high school graduates is estimated to be $1 million. Other forms of educational debt, like the debt you take on for occupational training or to gain additional skills that advance your career, can also be considered good debt. 

Even though student debt may be “good,” you should still weigh your options before you take it on, whether for yourself or your children. To begin with, there's a big difference between tuition at a public university versus an elite private school. Is it worth it? Maybe yes, maybe no. That’s for you to decide, based on factors such as: 

• How much you’ll need to borrow. 
• The field that you (or your child) will enter. 
• Your existing financial obligations. 

There are also signs that help may be on the way. With U.S. student debt at a record $2.6 trillion — second only to mortgages and more than credit cards and car loans — policymakers are debating how to make higher education more affordable. Plans range from free public college for all to generous loan repayment programs tied to income. 

If any of those ideas become a reality, good student debt will get even better. 

Home mortgages 

While a mortgage doesn’t increase your earnings potential, being a homeowner can provide some financial benefits. Your monthly mortgage payments go towards building an asset — home equity — and not to a landlord. 

Taking out a mortgage is often the only route to homeownership. Although the average age of first-time homebuyers is on the rise (the median age was 33 in 2019), few of us can buy our first home with cash. 

Even if you could purchase a house with cash, there are compelling reasons not to. Currently, the interest on a 30-year fixed rate mortgage is at or around 4%. Compare that with the S&P’s annual return, which averages around 10% for every 30-year period since 1926. Instead of having your cash tied up in an illiquid asset — your house — you come out ahead by investing that money in the market. 

But, as with student debt, potential homeowners have choices to make. 

While it’s true that you have to live somewhere, does it have to be in a $1 million home, or would a house at half that price do the trick? Even with the housing crisis in our collective rearview mirror, an estimated 40 million Americans are “house poor” — living in a home they can’t afford. 

The takeaway? You have to consider multiple factors before you determine if a particular debt is good for you. 

Small business loans 

Small business loans may represent more of a risk than other types of good debt— given historical success rates of start-up ventures — but they’re considered “good” based on the same assumption as student loans: You’re investing in yourself. 

The risk of these loans is balanced somewhat by the process you need to go through to get them. Whether you’re looking to borrow from the U.S. Small Business Administration or a bank, you’ll need to meet certain requirements, including personal and business credit scores. The SBA requires you to submit a detailed business plan with your application, so you’ll need to research your industry, identify risks, and set realistic goals. 

One thing is becoming clear: As much as we would like to define good or bad debt in absolute terms, the truth is more gray than black and white. 

New car loans 

We’re definitely in a gray area when it comes to new car loans. 

Having reliable transportation can increase your access to employment, so you could argue that car loans enhance your future earning potential. And for most of us (for better or worse), having a car is a necessity for daily life. 

On the other hand, your first drive out of the dealership in your new wheels is the most expensive trip you’ll take: Cars depreciate at an average rate of 20% in the first year, and 15% a year after that. If you take out a 5-year loan on a new car, you could be “underwater” before the end of the term, meaning you owe more than the car is worth. 

The good news? You have options. You can choose a $35,000 workhorse or an $85,000 show horse. If you buy a late-model used car with low mileage, the original owner takes the biggest depreciation hit. If you must have that new-car smell, try keeping your car after you’ve paid off the loan and putting that monthly payment into a savings account. That way, you can buy your next car in cash or put down a larger deposit and reduce your payments. 

Either way, you’re in the driver’s seat. 

Credit cards 

Regularly putting major expenses on credit cards is seldom a good idea, especially cards that lure consumers with interest-free initial offers and high credit limits. 

Although the average U.S. credit holder’s 2019 balance of $4,293 represents a lower percentage of disposable income than it did during the Great Recession, credit card interest rates have never been higher — 17.41% and counting. 

One problem with credit cards is their ease of use. The ability to pay with smartphones and other devices makes things even worse. And there’s online shopping, which elevates instant gratification and retail therapy to an art form. Try limiting yourself to a debit card that’s connected to your checking account, so you can only spend what you actually have. 

If you don’t need it, and can’t afford it, don’t buy it. 

Payday loans 

While credit card debt is not good, payday loans are even worse. Many workers turn to these lenders out of desperation — for example, to cover a car or home repair —which is never a good time to take on debt. 

Although the interest rates these “cash advance” lenders charge may seem manageable, they’re for shorter terms, usually until the next paycheck in two or four weeks. But on an annual basis, payday loan rates translate to an APR of 391%. 

The advice here is simple: Avoid at all costs. 

In the end, it’s about smart choices 

Like all major life choices, the decision of when and how much debt to take on — and for what — is complicated. Where are you in your career? How secure is your income? What are your financial obligations? Do you have a rainy day fund in place? Are you saving enough for retirement? 

One way to make it simpler is to ask yourself one question: What will this particular purchase mean to me in 15 years? 

How you respond may give you the answer you need, if not the answer you want. 

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