What’s the Difference Between Good Debt vs. Bad Debt?

Published on: Aug 11, 2021fb-roundtwitter-roundemail-round
Mortgage, Consumer Debt, Student Debt Design: ML Howell, Credit: iStock

The Story

Not all debt is created equal. Some types can actually benefit you in the long run.

Wait, there’s such a thing as good debt?

In theory. Debt that can help increase your net worth is considered good. Think: a mortgage that helps you become a homeowner. Or student loans that pay for your college degree, and hopefully lead to you getting a higher paying job. Another sign of good debt is that it usually has more favorable terms, like low(ish), fixed interest rates.

My student loan doesn't feel good. 

Even so-called good debt can be bad if it stops you from making progress toward your goals, like saving for retirement. Or the payments are so high that you can’t keep up on other bills. That's why it pays to only borrow within reason. If you overextend yourself, that debt is no longer helpful.

What's borrowing "within reason”?

There’s one number that can help you figure that out. Meet: debt-to-income ratio, or DTI. This measures how much of your gross (aka pre-tax) income goes toward paying off debt every month. And many experts say your DTI should be below 36%. Less is better.

To figure out your DTI, start by adding up all your monthly income. Include your paycheck, side hustle cash, and any other money you have coming in. Then add up your monthly debt payments (like for your student and car loans, mortgage, and credit cards). Divide your debt by your income, multiply by 100, and say 'hi, DTI.'

You haven’t mentioned the bad kind of debt.

Generally, that’s debt with high interest rates that do little to improve your financial situation, like credit cards. Instead, they keep you trapped in a cycle of accumulating and (hopefully) paying down debt. And carrying a balance costs you a lot. That’s not to say you shouldn’t have a credit card, especially if you earn rewards. But be careful about how you use it.

How do I use it?

Wisely. Whether it's good or bad, you want to keep your debt under control. Here are some ways to keep things in check:

  • Understand your debt terms. Before agreeing to anything, you should know your APR (hint: that’s how much you’ll pay in fees and interest per year, expressed as a percentage of the total amount borrowed). You should also know your estimated monthly payment amount and due date.

  • Pay on time and in full. Because payment history makes up 35% of your FICO score (psst...that's the credit score most lenders look at). And while you can get away with making the minimum monthly payment on your credit cards, knocking out the whole balance every month means paying $0 in interest, no matter the rate.

  • Keep your credit card balance low. Just because you have a large line of credit doesn’t mean you should use the whole thing. “Amounts owed” counts for 30% of your credit score. So maxing out your cards will bring down your score. Try keeping your credit utilization (aka the amount of available credit you’re using) under 30% at least.

Maybe I should aim for no debt at all?

That's the dream. But it may not be realistic. Most people can’t afford a house or college education without borrowing some money. But these things can help you build wealth. Plus, using debt responsibly helps build good credit, which you need for more than just borrowing: landlords, utility companies, and even some employers require it.

theSkimm

Before taking on debt, think about the possible outcome. Are you creating a future opportunity or potential problem? That’s the main difference between good and bad debt.

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Skimm'd by: Casey Bond, Sagine Corrielus, Stacy Rapacon, and Elyse Steinhaus