Whether it’s student loans, your mortgage, a credit card balance, or a car loan, you’ll find yourself with debt at some point. As you work to keep your debt in check and pay off your loans, it’s important to understand the concept of good debt vs. bad debt. Knowing the difference between the two will help you prioritize your debt repayment plan.
While some loans can help your financial health in the long term, others can quickly hurt it. Here are a few examples of good debt vs. bad debt that you might have.
How Much Debt is Bad?
Most people try to avoid debt at all costs. But is all debt bad?
Chelsea Fry, Vice President of Member Experience at Diamond Credit Union, advises that debt can be beneficial when used responsibly. “Debt, in general, has a negative connotation and gets a bad rap. Some of our members believe they should steer clear of debt or credit lines entirely, however that isn’t the best choice. Without any sources of debt on your credit report with recurring history, you will be unable to build a solid score or history. If borrowed in a responsible way and paid back according to the stipulations of the contract, it can be a great way to fulfill a lifelong goal of being a homeowner, furthering your career with education, or perhaps visiting a dream destination!”
Let’s break down the difference between good debt vs bad debt and see how they can affect your life.
What is Good Debt?
Good debt is represented by the loans that help you generate income or increase your net worth. Generally, good debt is something you’re able to repay responsibly based on the loan agreement.
For example, a mortgage or real estate loan allows you to build equity in a home, which increases your net worth over time. Student loans are another type of good debt since your education can boost your future earning potential.
Examples of Good Debt
There are several types of debt that can be beneficial to your financial situation. You might already have some of these without realizing it.
Student Loans
According to CNN, the average student loan debt for borrowers is $38,787. Although student loan balances can seem overwhelming, they have some benefits. Student loans are considered installment loans. Making installment payments in full and on time each month gives you an advantage — building your credit history and improving your credit score.
Student loans can also decrease your taxable income. The interest you pay on student loans can be deducted from your federal tax return.
Mortgage Loans
Like student debt, your mortgage is an installment loan and the interest you pay can also be tax-deductible.
Mortgage products vary and the type of mortgage you have will determine if it is an example of good debt or bad debt. A fixed-rate loan has set payments that won’t change over time, which makes repayment easier. An adjustable-rate mortgage can be more challenging.
After the fixed-rate introductory period ends, your interest rate and payment may increase. Non-conventional mortgages, including balloon mortgages and interest-only mortgages, can become harmful to your financial health after their initial benefits are gone.
Home Equity Loan or Line of Credit
Other examples of good debt are Home Equity Loans or a Home Equity Line of Credit.
A home equity loan is a one-time loan with a fixed interest rate that starts with a home appraisal, which then determines how much you can borrow based on your home’s equity. A home equity loan is good if a homeowner is looking to use the funds for a specific project or to pay off debt, like making large purchases, tuition payments, or home improvement projects.
A home equity line of credit (HELOC) has a similar process to a home equity loan, but it uses your equity a little differently and is a variable interest rate product. A HELOC can be described as a revolving door of funds that works similar to a credit card.
Small Business Loan
By using a loan to start or expand your business, you can generate additional income for yourself and your family. Additionally, a successful business can become a valuable asset that you can sell for a profit or pass on to your loved ones as an inheritance. This can help ensure a comfortable retirement for you and your family, providing financial independence and peace of mind.
What is Bad Debt?
Bad debt, on the other hand, does not work toward increasing your net worth. Credit cards and personal loans are examples because the money and interest you pay don’t necessarily increase your equity or improve your overall financial situation.
Examples of Bad Debt
These types of debt can be harmful to your financial health. It’s best to avoid them or pay them off as quickly as possible.
Credit Card Balances
A credit card is a revolving line of credit and you can use as much credit as you want up to the card limit. However, if you overuse a card and cannot pay back your monthly balance in full, your credit score can take a hit.
Additionally, credit cards typically carry double-digit interest rates, which means keeping an outstanding balance on your card means paying thousands of dollars in interest over time. According to data from the Federal Reserve Bank of New York and the U.S. Census Bureau, the average American household carries approximately $8,674 in credit card debt.
Regarding credit card debt, Chelsea Fry had these additional thoughts. “While it might be considered bad debt, having a revolving line of credit — when handled responsibly — is an important component to building a balanced credit history, as diversification is a positive. However, you should not have more revolving debt than installment debt.”
Auto Loans
Auto loans can be a bit of a “gray area” in the good debt vs. bad debt debate. Like other installment loans, they can be beneficial to your credit score. However, your car will depreciate with time and use.
An auto loan turns into an example of bad debt when you end up owing more on your loan than the car is worth. This happens when you are not required to make a down payment, or when you choose a loan with lower monthly payments over a longer loan term (six or more years).
Payday Loans
Payday loans are short-term, high-interest loans often used for small amounts, typically $500 or less. These loans are due on your next payday and can be received in cash, by check, electronically, or on a prepaid card. Unlike traditional loans, payday loans don’t require a credit or financial check.
Since payday loans can lead to a cycle of debt, they should be reserved for emergencies.
Ask Diamond About Your Debt
What’s your balance of good debt vs. bad debt? Talk to a Diamond representative about a Loan Health Check-Up. Through this convenient service, Diamond account specialists will ensure that you’re educated about your loans and credit report and offer options for financial soundness.
