Good vs. Bad Debt: A Quick Guide to Borrowing Wisely for Financial Success

Editor's Note: This story originally appeared on NewRetirement.

Debt is a concept that can be both daunting and confusing.

Most people think of debt as either a necessary evil or something to be avoided at all costs. Neither attitude is entirely correct.

There is actually a time and place for debt in most people’s financial plans. You just want to make sure that you understand the differences between good debt and bad debt.

Some debts can actually work in your favor, while others can lead to financial trouble. Let’s dive into the world of good debt and bad debt to understand the differences and implications.

Why Does Debt Have Such a Bad Reputation?

Nothing much good comes from credit card or excessive debt. This kind of debt puts unnecessary pressure on your household’s finances.

And, unfortunately, these kinds of debts are all too common.

According to Debt.org, Americans owe $986 billion on credit cards, surpassing the pre-pandemic high of $927 billion.

We owe $11.92 trillion on mortgages, $1.55 trillion on vehicle loans and $1.60 trillion for student loans.

Good Debt: Building a Strong Foundation for Growing Wealth

Good debt refers to borrowing money for investments that have the potential to grow in value or provide future benefits.

For example:

• Taking out a loan to finance your education or boost your business can increase your earning potential and open up career opportunities.
• Using a mortgage for a reasonably priced home can be considered good debt as it builds equity and provides shelter.
• Taking a loan to buy a car that enables you to get to and from work or provides other financial utility can also be considered good debt. However, cars range tremendously in value. Going into debt on a luxury vehicle is going to be mostly bad debt. Borrowing for a used car in great shape so that you can earn more money is good debt.
• Getting a home equity loan (borrowing on your own home equity) to do repairs or upgrades on your residence is another example of good debt.

Good debt focuses on investments that enhance your financial position in the long run.

Bad Debt: A Slippery Slope

Bad debt involves borrowing money for purchases that quickly lose value or do not generate income. Credit card debt accumulated from impulsive shopping sprees or luxury vacations falls into this category.

Bad debt drains your financial resources without providing any lasting benefits.

It’s like going down a slippery slope that leads to mounting interest payments and financial stress.

Seemingly Necessary Debt

Too many people find themselves in a situation where they must take on debt. Unexpected things happen in life all of the time that cost money.

You might get a speeding ticket, have a plumbing disaster at home, or experience a setback with your health that means you can’t work for a while.

Borrowing money may be the only way to overcome these setbacks. And, debt is how most people deal with unexpected expenses in life.

But, this kind of seemingly necessary debt is not good debt. The problem is that the debt puts you into a financial hole and makes it harder and harder to get ahead.

How to Avoid Seemingly Necessary Debt

A much better option than borrowing when disaster strikes is to be prepared for the unexpected. The first thing you should do to build a solid financial foundation is save and maintain an emergency fund.

Having constant access to a pool of money to use when you have a surprise expense will protect you from having to use debt to bail you out of trouble.

Explore how much emergency savings you should strive to have.

Responsible Borrowing

Whether you are considering “good debt” or “bad debt,” you want to be wise about your borrowing practices.

Here are some key rules to follow when it comes to borrowing responsibly.

Necessity

Only borrow when it’s necessary. Evaluate whether the debt is for an essential need or an investment that will improve your financial situation in the long run.

Try to only borrow for good debt.

Affordability

Borrow within your means. Consider your current financial situation and ensure that monthly payments fit comfortably within your budget.

Avoid taking on debt that stretches your finances to the breaking point. You may want to evaluate your debt-to-income ratio:

• The debt-to-income ratio is a financial measure that compares an individual’s monthly debt payment to their monthly gross income.
• According to Investopedia, 43% is the highest debt-to-income ratio a borrower can have and still get qualified for a mortgage.
• Lenders prefer a debt-to-income ratio that is lower than 36%.
• In general, the lower your debt-to-income ratio is, the better.

Comparison Shop

When seeking a loan, it is a good idea to shop around for the best terms. Compare interest rates, fees, and repayment terms from different lenders or financial institutions.

This allows you to secure the most favorable terms and save money in the long run.

Clarity

You always want to fully understand the terms and conditions of any loan. Read and understand the fine print of loan agreements or credit contracts before signing.

Pay attention to interest rates, repayment schedules, any penalties, and fees involved. Clear understanding helps you avoid surprises and make informed decisions.

Monitoring

Lenders, particularly credit cards, sometimes have the option of switching your interest rate. It is important to monitor your loans and always strive to lower your interest rates.

Regularly assess your debts and their impact on your overall financial situation. Consider refinancing options, debt consolidation, or adjusting your borrowing strategy as needed.

Discipline

Borrow responsibly and limit your borrowing. Avoid taking on excessive debt that you may struggle to repay.

Be disciplined in your borrowing habits and resist the temptation to accumulate unnecessary or frivolous debts.

Repayment

Make timely payments. Stay on top of your repayment obligations and make payments on time.

Late payments can lead to additional fees, higher interest rates, and a negative impact on your credit score.

Strategy

Have a borrowing and repayment strategy. Consider the purpose and impact of each debt you take on.

Prioritize debts that contribute to your long-term financial goals and minimize high-interest or unnecessary debts.

Learn more about different ways of getting out of debt.

Communication

Communicate with your lenders.

If you’re facing financial difficulties or anticipate challenges in making payments, reach out to your lenders proactively. They may offer assistance, such as revised repayment plans or hardship programs.

Education

Continuously educate yourself on personal finance. Stay informed about borrowing best practices, financial management, and debt-related topics.

Empower yourself with knowledge to make informed decisions and protect your financial well-being.