Good Debt, Bad Debt: What’s the difference?
Craig Donofrio — Break It Down
Sometimes it feels like wherever you spend, there you are: in debt. But for many Americans, debt is more than a feeling—the average U.S household carrying debt had about $135,900 of it as of March 2017, according to a NerdWallet analysis.
However, even financial experts agree that some debt—managed responsibly—can be a good thing, and that’s where it gets tricky. It all depends on knowing the difference between good debt and bad debt.
Good debt is an investment that will further your financial standing over time.
“One of the principles of gaining wealth is to accumulate assets that are worth more than the debts it took to acquire them,” says Corey Vandenberg, a mortgage consultant with Platinum Home Mortgage
Anything that falls under this definition can usually be considered good debt. For instance, in general a home mortgage boosts your credit score, increases your net worth, and often costs less than long-term renting. And the asset the mortgage financed—your home—can usually be sold later at a profit. A business loan helps you create an income-generating company which can also be sold later at a profit, under the right circumstances.
Of course, you may still be taking a significant gamble even with good debt. Exhibit A: the Great Recession, when millions of home mortgages ended up underwater and the housing market crashed. Exhibit B: Any one of the millions of failed businesses. But if you’re responsible and reasonable regarding the loan amount and payments, good debts can push you ahead in life.
Bad debt “literally makes you poorer from a net worth perspective,” says Vandenberg. Unlike good debt’s ability to help you afford assets that appreciate in value over time, bad debts suck up your cash and don’t give you any wealth in return.
Credit cards with high interest rates and annual fees generate bad debt. Payday loans are one of the worst offenders. Think your annual 22 percent credit card rate is bad? Payday loans average rates hover around 391 percent often for loans worth just a few hundred bucks.
There is a silver lining: If you pay off your credit cards faithfully each month, you’ll build up good credit. But if you’re unable to pay the balance off each month, you’ll start to accumulate interest.
An investment in something that depreciates in value counts as bad debt too, if you finance it. A car loan is considered a bad debt because a car depreciates in value pretty much as soon as you drive it off the lot—not only will you not be able to recoup the cost, you’re also paying interest on the loan.
You may be thinking: “But my car gets me to work, which helps further my career, which will make me wealthier over time!” And that’s true: Your car can enrich your life. But a mortgage underwriter, for instance, is going to view a car loan as a bad debt since it decreases your net worth. Same with your new work clothes that you charged to your AmEx. That’s just how it works out on paper.
The evolution of good and bad debts
To further muddle things, the definitions of good and bad debts are changing. The best way to illustrate this is student loans. For years, student loans were the go-to example of good debt, right alongside mortgages. Taking out money to further your education should, in the long run, help you earn more money via job opportunities that require a college degree. The data is there to support that theory: In 2015, college graduates earned 56 percent more than high school grads. While the Bureau of Labor Statistics reported that only 17.5 percent of all jobs in 2016 required a bachelor’s degree, another study found that college graduates disproportionately get more jobs than those with only a high school diploma. That study, out of Georgetown University, found that between 2010 and 2016—the Recession recovery years—only 80,000 people with a high school diploma or less landed a job. Compare that to jobseekers with at least a bachelor’s degree who landed 8.4 million jobs and 3.1 million jobseekers with some college or an associate’s degree who were hired in that time, and it sounds like student loans are indeed good debt.
So what’s the problem?
“So many people I’ve met have degrees in a field they don’t use,” says Vanderberg. “Now they’ve spent money for their education and it casts a shadow—they can’t buy the house they want, or live the way they want, because they’re saddled with debt.”
So if you take out an exorbitant amount of money for a fancy degree and subsequently land a job that could have been had for a degree that cost half the price, it’s not exactly good debt.
Not only that, but you seriously cannot get rid of that loan unless you pay it off, fulfill some specific public service repayment plan, drop dead, or have a rare circumstance where the loan can be discharged. The government seems to view student loans as not-so-great debt too, since it recently declared that deferred student loan debt will be considered when applying for government-backed mortgages.
Similarly, a mortgage can turn into bad debt if the home goes underwater—meaning your mortgage is worth more than your house—or if you purchase a home you can’t afford. While financial reforms since the Recession have barred the most egregious types of home loans, there are still some bad deals to be had. A skyrocketing adjustable-rate mortgage or a high-interest low documentation (“low-doc”) loan can all put you closer to financial distress than wealth.
So, if you’re still paying off a not-so-lucrative college degree, or took out a loan for a vehicle so that you can get to work, you’re in a gray area for debt—some bad debt can facilitate good financial decisions and vice versa. Of course, if you take out an auto loan to pay sticker price for a brand new car when you’re already struggling with bills, that debt was neither necessary nor good. That’s just dumb, and dumb debt is the one type of debt you can always avoid. Thankfully, it’s easy to spot.
Dumb debt is “buying anything you can’t really afford,” says Vandenberg.
That one is easy enough.