Good Debt vs Bad Debt: What is the difference?

The financial team at SlickCashLoan sees many people getting into a lot of trouble by borrowing money, only to later scratch their heads over why the loan balance never seems to drop.

It is rarely due to being trapped with debt. It is normally because the type of debt they borrowed was bad debt, and they did not have a good plan in place.

Debt can be a great tool, but it can also be a big trap. The important thing is to determine what kind of debt you are dealing with before you sign on the dotted line.

A simple way to think about it is by using the concepts of value and cost. In general, good debt is typically used to create an asset that will increase in value or to increase future earnings. Bad debt is simply a cost you are paying that decreases your assets.

A quick way to think about what is good debt and what is bad debt

Category	Good debt	Bad debt
Why you are borrowing it	Funds something with potential to increase in value, or something to enhance your ability to earn money	Funds short term needs that will decrease in value over time
Interest rate/fees	Lower interest rates than those associated with bad debt, which makes budgeting much easier	Higher than those associated with good debt, and as such can add up quickly
Long-term impact	Aids in increasing net worth and improving your credit profile	Erodes cash flow and increases your overall risk

There is no chart that can provide a judgment on every case, but this table gives you an idea of where to begin thinking.

What makes debt “good”

Just because you have good debt does not mean it is free money; you still need to make timely payments. However, the important concept here is that the payments you make are toward something that will remain after the payments stop.

Good debt usually comes in a few forms:

A mortgage allows someone to purchase a home and potentially appreciate over time. Each payment made on a mortgage creates equity (the part of the property that is owned and not owed to a lender) and allows homeowners to build wealth.

Mortgages generally have a longer repayment term, which keeps the monthly payments stable.

Student loans allow individuals to borrow money to pursue education and/or training, which may result in increased earning potential in the future. Student loans are bad debt if there is no plan to repay them once graduated from school.

Business loans provide capital to small businesses to either purchase equipment/tools, inventory, or work vehicles to generate revenue and hopefully earn more than the loan cost. There is a significant amount of math involved when taking out a business loan; however, a well-planned loan can greatly enhance the growth of a business.

Ultimately, good debt typically serves a greater purpose than the current day-to-day expenses. The funds borrowed will continue to produce benefits for years to come.

What makes debt “bad”

Bad debt tends to cost more and leave little behind. A high rate is also a warning sign of bad debt. A short payoff window for a balance due on a loan is also a warning sign. If you are making regular payments on a loan and the outstanding balance is increasing rather than decreasing, this too could be a warning sign of problems with your debt.

A common example of bad debt is credit card debt. While credit cards are great when you pay off the entire amount due every month, problems arise when you carry a balance from one month to the next. Interest can pile up fast on an unpaid balance, and small minimum payments will keep you in debt for a long time.

Expensive short-term loans may eventually lead to bad debt. Payday loans are typically short-term loans with an extremely high cost. Although at first glance the charges seem reasonable, they will become pricey when the cost is broken down over a full year. Many consumers will find themselves needing to take out another loan to pay for the initial loan, and this creates a cycle that is difficult to get out of.

A car loan is typically somewhere in the middle of the spectrum; a new car loses a large amount of its value rapidly. Many people need to get a loan to purchase a car for work or for their family, yet a car loan rarely creates wealth. Paying off your loan as early as possible with a short term will minimize the financial risk associated with taking out a car loan.

Bad debt often covers short-term comfort as opposed to long-term value, and the bill remains long after the benefits are gone.

A simple test before taking any loan

Our team uses a short set of questions. A person can run through the questions in a minute:

• Do you think the money will allow you to make more money down the line?
• Do you think the money will help you save money down the line (like paying off a high-rate credit card)?
• Will the thing or goal be important to you once you pay back the loan?
• Can the monthly budget still work if things get worse for a few months?

If the answer is “no” across the board, then it is probably a bad loan.

The gray area loans that depend on use

There are some types of loans that simply do not have an inherent quality to them as being “good” or “bad.” A personal loan is a great example of this type of loan.

If you’ve got multiple high-interest credit cards and you take out a personal loan at a lower interest rate, you can use it to consolidate those multiple payments into one easy-to-manage fixed monthly payment. It can literally save your life, but be careful not to keep running up new card debt while you’re paying off the old balances. If you do that, you’ll never get out from under all that debt.

Taking out a personal loan for a vacation is generally a bad idea. The vacation will be long gone before the loan payments are paid off.

The borrower’s intentions are also a factor in what type of home equity loan will work best. Borrowing money to replace your roof (protecting your investment) or doing a low-cost kitchen remodel could both be good uses. However, spending money you borrow from your home for a luxury item is usually risky because of the potential loss of control over your mortgage payment and the risk of losing your home.

Debt management that works in real life

Everyone has some form of debt. We want you to be confident about managing your debt — we don’t want you to be ashamed.

The first step toward taking back control of your finances is to list out each of your balances and due dates. Once you know what you are working with, it is time to consider the interest rates associated with each of your debts as well as the monthly payments you are making.

Paying extra money toward your most expensive (highest rate) credit card or loan as you make the minimum payments on all other debts is a popular way to save money long-term. Paying off your least expensive (smallest balance) credit card or loan first also builds momentum. As long as you continue to pay on time and stop adding new debt, you will be successful either way.

Review your budget for any areas where you may be losing money each day. Daily losses can add up to big money over time. A small cut in your spending can provide enough funds to go toward debt repayment.

If making payments appears impossible, contact your lender prior to a missed due date to see what type of assistance they can offer (hardship option, payment modification, or temporary pause). Not all lenders will provide an option for assistance; however, contacting them early is better than waiting until it is too late.

Next steps

While you do not need perfection in your smart plan, it should have clarity in choices.

First, sort your current debt into three categories: most likely good, most likely bad, and depends on how you use it. Next, determine which of these debts will be your payoff priority based upon either the highest cost or the one causing the most financial stress. As soon as possible, establish an emergency fund. An emergency fund may prevent costly last-minute borrowing.

Debt can be a useful tool or destructive depending on the purpose, cost, and whether you have a realistic way to pay off the debt.