What Is “good” Debt?
Each Monday, we address one of your pressing personal finance questions by seeking advice from several financial experts. If you have a general question or money issue, or just want to talk about something PeFi-related, leave it in the comments or email me at [email protected].
This week’s question came from an anonymous reader via email:
I see all the time that certain types of debt (mortgage, student loans) are called “good” debt, while other types (like credit card debt) are called “bad” debt. What does it mean? What makes a certain type of debt “good” and another “bad”?
Good question, Anonymous! This is what individual experts say about an issue that affects each person differently – if you need personalized advice, we recommend that you see a financial planner.
Good debt versus bad debt
One of the main differences between “good” and “bad” debt is the interest rate. Credit cards, for example, have high rates compared to other financial products such as some car loans or student loans. If you don’t pay your credit card bill every month, the balance can easily slip away from you as interest accrues.
On the other hand, a form of “good” debt is a mortgage. “These types of loans have fixed monthly payments that not only prevent interest from being added to the loan balance , but also help borrowers pay off some of their debt each month,” says Doc David Trees, financial analyst at FitSmallBusiness.com . Having this type of debt will likely improve your credit score, while credit card debt will damage your account.
But it’s not just the interest rate. Another way to find out how “good” he is is by how protected he is. Secured debt is tied to collateral, while unsecured debt (such as credit card balances, payday loans, and medical bills) is not. “In truth, this is a big reason the interest rates are so much higher,” says Tris. If, for example, you run into debt on a credit card, the lender can hire a debt collector or go to court to withhold your paycheck until you start paying. Again, this will be reflected on your credit report.
“Good” debt is usually secured by houses, cars, or other tangible assets that can be returned to the property if you are late in making payments. Government-sponsored student loans are considered “good” debt, or at least better than private loans, which tend to have higher rates and are not secured. Basically, if it increases your net worth, it is “good” debt. If it lowers your net worth, that’s “bad” (car loans can go anyway).
“The main consideration that makes some debt ‘good’ debt is that it is an investment in profitability or an asset that will increase in value over time,” says Tris. Real estate becomes more expensive over time, and student loans increase a person’s profitability.
If you have money to spare, it will be most beneficial for your bottom line to prioritize paying off your bad debt at high interest rates. However, many people are successful with the snowball method , which prioritizes the smallest debt and then builds up to larger debt. This is by no means a universal situation – find a debt settlement plan that works for you.