Good Debt vs. Bad Debt: Is There An Actual Difference?

Debt is a four-letter word that can keep you up at night. But it can also be a means to an end. Understanding the difference between the two types of debt and managing both are key to your financial health. 

Often debt is deemed good if it allows you to obtain an asset to grow wealth—think business loans, home mortgages, and student loans, for example.

"They are considered good because of the opportunity to either generate income or grow an asset that will be worth more money later on," says Caitlynn Eldridge, a certified public accountant and founder of Eldridge CPA. 

Mortgages are deemed good debt because historically, home values have increased over time, with an average appreciation rate of about 3-5% per year, points out Jeff Rose, a certified financial planner and founder of GoodFinancialCents.com. 

If you're wondering what distinguishes the good from the bad, bad debt is labeled as such if it comes from buying things that go down in value, such as cars, and credit card purchases for furniture and clothes, for example. 

Bad debt also typically has high interest rates, causing you to pay even more than the original price if you don't pay off the bill in full when it arrives. The median rate of interest across all credit cards in the Investopedia card database for September 2023 was 24.12%. 

The rates are worse for payday loans. "They can exceed 400%," says Rose.

The consequences of bad debt can be severe. Your credit score may decrease, your borrowing capabilities may be more limited in the future, and that heavy debt burden could get in the way of your saving and investing goals. You could end up filing for bankruptcy.

Truth is, all debt should be managed carefully and monitored. "Even 'good' debt can become bad if you have more than you can pay off," says Eldridge. 

You want the lowest interest rates possible on any debt and to pay it off as quickly as possible. 

Be savvy about debt. "You need to really evaluate costs. If you are buying something on 12 months at 0%, then it goes up to 18%, can you pay it off in the 12 months?" asks Gina Knox, CEO and financial coach and Gina Knox Coaching. 

If you can't pay it off within 12 months, you're not getting the great deal you think you are. When the interest rate switches to 18%, can you say that cost will be worth it? "This is the type of question you want to answer prior to buying," says Knox.

You won't go too far astray if you stick to this rule. "Before you take on debt, whether good or bad, first have a positive cash flow from your current income," advises Raymond Quisumbing, a registered financial planner at BizReport.

Secondly, save a decent amount of money to serve as your emergency fund (equal to at least six to 12 months' worth of monthly expenses); only then should you consider borrowing, and it should be for good debt.

Stephen Chang, managing director at Acts Financial Advisors, also says before undertaking any type of debt, to do a bit of soul searching. "Do a needs-versus-wants analysis. Evaluate where the purchase falls within that rubric," he says.

Much as in an ideal world you would be debt free, that's more wish than reality for many people. But what's key is to have a plan to pay off debt.

"Whether healthy or unhealthy, debt is not something you want to live with. Get a simple budget in place (app, spreadsheet, pencil, and paper), and incorporate payments for whatever plan you've chosen," says Sean Fox, president of debt resolution at Achieve, a digital personal finance company.

The best option is to pay off the bill in full when it comes so you avoid interest charges. But that may not be possible. One way to reduce debt is to use the snowball method, paying off debt starting with the smallest amount owed to largest. Make minimum payments on all your debts except the smallest, where you pay as much as possible until finished. Follow suit with your remaining bills. Knocking off a bill is a victory that keeps you encouraged.