If you spend much time reading about money and credit, at some point you’re likely to come across the concept of “good debt vs. bad debt.” Some people would argue that there is no such thing as good debt and that any debt is bad. There is some validity to that position because, in most circumstances, you’re paying something to service your debt, such as interest or fees.
I imagine most people would prefer to be 100 percent debt-free and not have to make any kind of monthly payment outside of the normal cost of living. Things like Internet service, cable and utilities will always be a fact of life for you. I don’t really consider those to be garden-variety debts though. I’d rather just call those “the cost of living.”
So unless you get really lucky and pick six numbers and win the lottery, debt may be a necessary evil. But, it doesn’t really have to work against you. Some debts work for you, like a mortgage or car loan. Some people borrow money to start a business. Some people, a lot of people rather, borrow money to fund their education, thus making them more valuable when they enter the work force.
The idea behind the concept of good debt versus bad debt is this: Good debt may put you into a better financial position in the future. Bad debt, on the other hand, likely leaves you worse off financially.
All debt is optional and voluntary, a fact many people overlook when criticizing lenders. When it comes to choosing whether or not to incur debt, it’s a good idea to weigh the pros and cons before you make a financial commitment. You should ask yourself whether you can afford the debt and whether the debt you’re considering is working for you or against you.
Debt That Works for You
Good debts often have the potential to help you generate some form of income or wealth. Good debt also helps or otherwise allows you to make purchases that could increase in value or might increase your net worth. And, it’s common for “good debts” to include lower interest rates and tax advantages.
Here are a few examples of the types of debts that many financial experts might consider to be “good.”
- Mortgages, because you need somewhere to live and, generally, homes increase in value
- Student loans, because college educations can lead to more earning power
- Some business loans, because nothing beats being your own boss!!
- Home improvement loans, because they can increase the value of your home
- Sensible auto loans, because you have to get from point A to point B
Debt That Works Against You
Debts that are expensive and have no ability to increase your income or net worth are typically considered “bad” debts. Bad debts are often notorious for carrying higher interest rates and no real tax advantages.
Here are a few examples of the types of debts that many financial experts might consider to be “bad.”
- Credit card debt, because the average interest rate is pretty close to 20 percent
- Irresponsible personal loans, like those that fund vacations, weddings and shopping sprees
- Payday loans, because, when annualized, their interest rates are several hundred percent
- Tax-refund anticipation loans, because you can wait a few weeks for the check to show up
- Asset loans (pawn loans, title loans, jewelry loans), because they’re also super expensive
Debt That Can Hurt Your Credit Scores
Of course, not everyone will agree with the classifications above, which is fine. There will always be some debate in the financial community over which debts may be considered good and which debts may be considered bad. However, there’s no question about the kind of debt that is bad for your credit scores — credit card debt.
Credit card debt has the potential to damage your credit scores even if you make every single monthly payment on time. Why? Because using a high percentage of your available credit limits makes you a riskier borrower. That’s based on research, not ideology.
Installment debts aren’t treated the same way by scoring models. In fact, if you compare a $300,000 mortgage loan to a $3,000 maxed-out credit card, it’s the credit card debt that will damage your credit scores rather than the much larger mortgage.