Good debt vs. bad debt: What’s the difference?
It’s easy to think that all debt is bad. But like most things, it’s not that simple.
When managed responsibly, debt can be helpful. Certain types of debt can even be part of building wealth. Knowing the difference between what’s considered good and bad debt—and how to handle each—can help you figure out how to manage it all.
- Debt can be good or bad—and part of that depends on how it’s used.
- Generally, debt used to help build wealth or improve a person’s financial situation is considered good debt.
- Generally, financial obligations that are unaffordable or don’t offer long-term benefits might be considered bad debt.
- Any debt that might be considered good has the potential to become bad if it’s not managed responsibly.
What is good debt?
Good debt typically refers to debt that helps you reach your financial goals—like owning a home, paying for school or starting a business. Debt might also be considered good if it helps you build credit.
But remember: Part of what separates good debt from bad debt is how it’s managed. This means using credit responsibly, like making monthly payments on time. Loans and credit cards can help open new doors and opportunities, but there are no guarantees. And any debt you can’t pay back on time could end up being considered bad.
Examples of good debt
Here are a few types of debt that can be considered good debt under the right circumstances. Keep in mind, though, that any type of debt could potentially become bad debt in different circumstances—if you can’t repay it or it negatively affects your credit scores, for example.
Monthly mortgage payments build equity. And this could lead to a higher net worth. And interest paid on a mortgage can sometimes be tax-deductible.
Financing education can be necessary to get a degree, and a degree has the potential to increase earnings. Student loans typically have lower interest rates, compared to other lines of credit. Plus, the interest can be tax-deductible.
Taking on debt to start a business can be helpful for building wealth. But it’s a good idea to keep in mind the risks of starting a business before taking out a loan.
A personal loan can be helpful for consolidating debt at a lower interest rate. And if it’s an unsecured personal loan, you may not need collateral—like your home—to secure the financing.
With responsible use, credit cards can help build credit, which can help you do things like borrow money, get a credit card or rent an apartment. Making the minimum payment on your credit card over time may help keep your account current and in good standing.
What is bad debt?
Some types of debt may not be as good as others. Debt might be considered bad if it’s difficult to repay or doesn’t offer long-term benefits—think loans with high interest rates or unfavorable repayment terms, for example.
If you’re considering taking on debt, it might help to consider what it could do to your debt-to-income (DTI) ratio. Your DTI ratio is what you earn relative to the debt you owe. If you’re taking on a debt with a monthly payment that is beyond what you earn each month, it could make it hard to pay back. That may be a sign it’s not the right move.
Examples of bad debt
Here are a few types of debt that might be considered bad debt.
Debt you can’t afford
Debt you aren’t able to pay back on time might be considered bad debt. For example, a home purchase could end up being a good buying decision for someone who has the income to make their monthly mortgage payments, and it might ultimately improve their credit. But borrowing money to buy a home wouldn’t be considered good debt if the purchaser isn’t able to make consistent payments over the life of the loan.
Payday loans generally offer short-term, high-interest loans, often without requiring a credit check. These types of loans can have higher interest rates, and you usually have to pay them back by your next payday.
Payday loans usually don’t get reported to any of the major credit bureaus. That means even if you do make on-time payments, your credit scores probably won’t reflect it.
Debt that negatively affects your credit scores
Debt that affects your credit scores in a negative way is an example of bad debt. This can even happen to a good debt if it isn’t responsibly managed—say, if you fall behind on payments or if your credit utilization ratio increases.
How to avoid bad debt
Debt happens. It’s what you do with it that determines whether debt could be good or bad. And while it’s not always possible, it can help to figure out whether the debt you’re taking on is something you can afford. Here are some tips to help:
- Review your possible monthly payment. Would this new bill be something you can actually afford?
- Look at the interest rate. The lower the interest rate, the less interest you could pay over the life of the loan.
- Think about your long-term goals. Will borrowing this money help or hurt you in the long run?
Good debt vs. bad debt in a nutshell
Debt can be beneficial—for example, when it’s used to improve a person’s overall financial situation and increase their net worth. If you’re looking to buy a home, pay for your children’s college education or retire comfortably, check out these tips on how to build wealth.
It can help to stay within your means whenever possible and make required payments on time. If you’re struggling to keep up with your bills, check out these tips on how to get out of debt.
It’s a good idea to keep a close eye on your credit. One way to monitor your credit is by using CreditWise from Capital One. With CreditWise, you can access your TransUnion® credit report and VantageScore® 3.0 credit score—without hurting your score. CreditWise is free for everyone, and you don’t even have to be a Capital One customer to enroll.
You can also get a free copy of your credit report from each of the three major credit bureaus—Equifax®, Experian® and TransUnion. Visit AnnualCreditReport.com to learn how.
We hope you found this helpful. Our content is not intended to provide legal, investment or financial advice or to indicate that a particular Capital One product or service is available or right for you. For specific advice about your unique circumstances, consider talking with a qualified professional.
Capital One does not provide, endorse or guarantee any third-party product, service, information, or recommendation listed above. The third parties listed are solely responsible for their products and services, and all trademarks listed are the property of their respective owners.
Your CreditWise score is calculated using the TransUnion® VantageScore® 3.0 model, which is one of many credit scoring models. It may not be the same model your lender uses, but it can be one accurate measure of your credit health. The availability of the CreditWise tool depends on our ability to obtain your credit history from TransUnion. Some monitoring and alerts may not be available to you if the information you enter at enrollment does not match the information in your credit file at (or you do not have a file at) one or more consumer reporting agencies.