Debt has become a way of life for many Americans. According to the Federal Reserve, total household debt rose by $312 billion in the second quarter of 2023 to reach $16.15 trillion.
While debt is a fact of life for most, it’s important to know that not all debt is created equal. Using debt irresponsibly could have dire financial consequences, but it can also be a wealth-building tool when managed properly.
Most experts categorize debt into two categories: good debt and bad debt. Here’s a breakdown of a few different types of debt and which category they fall into.
|Good Debt||Bad Debt|
|Real Estate Loan||Credit Card|
|Business Loan||Store Credit Card|
Good debt is any debt that can help you increase your net worth and build wealth. This might include a student loan that helps you afford an education, a mortgage that will eventually be paid off, or a business loan that will give you the capital you need to build a successful business. While you’ll still have a regular payment to factor into your budget, good debt is an investment that pays off in the end. However, good debt isn’t without risk. You should follow a few rules of thumb to help you mitigate that risk, such as shopping around for the lowest interest rate possible and creating a timeline for repayment.
In contrast, some forms of debt can create greater financial difficulties down the line. Bad debt typically includes any high-interest consumer debt that doesn’t contribute to meeting long-term financial goals. This might include a high-interest credit card with a balance carried over from month to month, an auto loan with unfavorable terms, or a store credit card that encourages overspending.
What distinguishes good debt from bad debt is that bad debt funds depreciate assets, while good debt provides access to an asset that will increase in value over time. In terms of interest rates, bad debt generally has higher interest rates than good debt.
You could find yourself in a situation where you’re paying more than the asset is worth because you’re making payments over a long period at a high-interest rate.
Things To Consider When Taking Debt
Can you afford the monthly payments on your student loan, mortgage, or line of credit? And what would happen if making those payments became too difficult? Would you be able to give yourself some extra financial breathing room?
Debt can be a scary thing. It can feel like you’re never going to escape it. But there are ways to make your debt more manageable. You can look into payment plans, late fees, and debt relief programs. Prepare for the worst-case scenario and determine whether the reward of having access to those extra funds outweighs the risk.
Last but certainly not least, you need to figure out how this extra debt will help you long term. Once you’ve paid off your debt, you don’t want to be left with an asset that has depreciated and isn’t worth much. Consider your options and make the best decision for your future self.
Can You Have Good And Bad Debt At The Same Time?
Different types of debt can have different effects on your financial situation. You want to limit yourself to the mostly good debt you can afford to repay because otherwise, the debt might become problematic. Although bad debt happens, it is not the end of the world. The most important thing is to plan to minimize those balances, especially on credit cards. However, sometimes taking on bad debt can be worthwhile, for example, when making a purchase that will benefit you in the future.
Protect Your Finances While Having Bad Debt
Bad debt can be a real problem, but you can protect your finances by managing it properly.
Auto loans aren’t necessarily bad – they can help you get to and from work. But credit cards are another story. They can harm your finances unless you keep them under control and eventually pay them off.
Fortunately, you can take steps to shield yourself from financial ruin. Start by committing to stop using credit cards for purchases. Then, look at your spending plan and see where you can free up some funds to pay down your credit card balances faster. Once you have a figure in mind, create a debt payoff plan that works for you—the debt snowball and debt avalanche are two popular options.
It’s also important to create an emergency fund so that you’re not forced to use credit cards again in the event of a financial emergency.
Assuming more debt is a personal choice that requires thoughtful consideration of all the potential costs and benefits. When assessing whether taking on new debt makes sense for you, you’ll need to factor in the principal payment, interest rate, late fees, and penalties. Weighing these numbers against the value of your asset will help you decide whether this new debt is a good idea.