It is important to know the differences between good debt and bad debt for better loan management.
Good debts are loans that help you to build wealth and income gradually. For example, taking a mortgage to buy a home or, real estate investment loans are good loans because they offer you an opportunity to utilize the finance and build cumulative wealth.
On the flip side, bead debts do not help increase the net worth. For example, credit card liability never helps accumulate net wealth. Credit cards, payday loans, car loans, and holiday financing are examples of bad loans that depreciate your wealth over time.
Understanding the core differences between good and bad loans will help you to ensure financial stability, enhance your credit score, help manage costs, and contribute towards overall financial self-sufficiency.
I would like to refer to the UK’s property price. In the UK, the average mortgage interest rate was 7.92% for a Standard Variable Rate (SVR) and 5.00% for a two-year fixed-rate mortgage as of April 2024. Interestingly, since 1991, home prices have risen by an average of 298%. (Research archives, UK Parlament).
That represents, those who recognize the good loans and utilize their money over the good debt, multiplying the wealth by several times.
Similarly, In the UK, the average credit card debt per household was £2,476 as of February 2024, with an average interest rate that can exceed 20%. It would take over 26 years to repay this debt making only minimum payments each month (source: House of Commons, UK parliament).
In the USA, the story would be pretty similar to the UK which draws attention to discriminating both debt types.
Key takeaways
- Good loans are cheaper than bad debts
- Good loans increase borrowers’ wealth
- Bad loans depreciate net worth
- Bad loans are expensive and some are unnecessary (such as whopping with available credit limit)
- Understanding the core differences helps in better debt management
What are the good debts?
Good debts are loans that typically help to increase the borrower’s net wealth. Normally, such loans come with lower interest rates and are used for investments that can appreciate or generate future income.
What are examples of good debt?
Mortgage, student loans, business loans, and real estate investment loans are good debts.
Taking out a mortgage to buy a home is considered good because real estate often appreciates over time, building equity. Homeownership also provides stability and can be an asset for the future that can be used as collateral for further borrowing opportunities.
Similarly, loans for higher education are generally seen as good debt if they lead to higher earning potential. For example, college graduates earn significantly more than those with only a high school diploma.
Similarly, any loans to start a business are also good debt if they lead to increased revenue and profitability. Investing in a business can generate long-term income and build an asset that can be sold or passed on.
Furthermore, loans to purchase rental properties or other real estate investments can also be good debt because these properties can generate rental income and appreciate over time
What are the bad debts?
Bad debts are loans that do not help increase borrowers’ net wealth and often come with high interest rates. This type of debt can lead to financial strain and long-term economic issues.
What are the examples of bad debts?
- Credit Card Debt: High-interest credit card debt is a common example of bad debt. It often results from purchasing depreciating items and can quickly accumulate due to high interest rates, making it difficult to pay off.
- Payday Loans: These short-term, high-interest loans are designed to be repaid with the borrower’s next paycheck. However, they often lead to a cycle of debt that is hard to escape due to the cumulative interest rates and additional fees.
- Auto Loans: While necessary for many, auto loans can become bad debt if the terms are unfavorable or if the vehicle’s value depreciates faster than the loan is paid off. For instance, someone may buy a car that will not have any resale value after two years but, the borrower needs 4 years to repay the loan in full. Long-term auto loans can result in paying more interest over time, which can be financially burdensome. Auto loans can also be good debt if the borrower does a side hustle such as Ubering, or delivering the job on top of his profession.
- Personal Loans for Discretionary Spending: It includes taking out loans for non-essential expenses, such as vacations or luxury items, which often leads to bad debt. These loans typically do not contribute to wealth-building and can strain finances if not managed properly
Why should you recognize Good and Bad Debt?
In a nutshell, recognizing the good and bad loans will help you to achieve financial stability by optimizing regular costs. It will also help you to build a good credit score by avoiding unnecessary loans and late payments.
Below are the core benefits of recognizing the good and bad loans:
- Understanding which debts are beneficial can help maintain or improve financial stability. For example, good loans will maximize your net worth whereas bad debts will always cause financial strain.
- Understanding the loan types will help you manage your debts easily and follow a structured budget that eventually contributes to the overall financial plan.
- Good debt can positively impact your credit score if managed well, leading to better-borrowing terms in the future. On the flip side, accumulating bad debt can harm your credit score, making it harder and more expensive to borrow money when needed.
- Utilizing good debt can unlock future opportunities. For example, building an asset over time will generate additional income and the asset can also be used as collateral for further loans.
What are the core differences between good and bad debt?
In short, good debts help the borrower to maximize net worth whereas bad debts create financial strain. Also, bad debts are always more expensive than good debts with tougher payment terms. To be very honest, bad debts never create assets for the borrower.
Here’s a side-by-side comparison table for good and bad debt:
| Criteria | Good Debt | Bad Debt |
|---|---|---|
| Definition | Increases net worth or future income | Does not increase net worth; high-interest |
| Examples | Mortgages, student loans, business loans | Credit card debt, payday loans, long-term auto loans |
| Interest Rates | Lower interest rates | High interest rates |
| Financial Impact | Positive impact on credit score | Negative impact on credit score |
| Future Benefits | Provides opportunities for growth | Limits future opportunities |
| Repayment Terms | Favorable, fixed interest rates | Unfavorable, variable interest rates |
| Asset Creation | Leads to valuable assets (e.g., homes, businesses) | Used for depreciating assets or consumables |
The main difference between bad and good debt is the cost and asset creation. If you compare mortgages with credit cards, the cards we use are always more expensive than the home loan. Additionally, credit cards or payday loans never help us to build an asset for the future.
Similarly, good loans never create financial strain. For instance, someone with a mortgage or an education loan will never suffer from monthly payment difficulty if the loan management way is appropriate. If someone is getting a home loan, we can reasonably assume that the person definitely can pay regular monthly mortgage payments.
From the aspect of financial impact, good debts never hurt the borrowers’ credit score but the bad debt does. For example, carrying a large credit card balance eventually lowers the credit score but having a 10-year mortgage will never negatively affect the score if monthly payment is regular.
How would you manage your debt efficiently?
Managing a debt portfolio requires adequate knowledge and decision-making ability. Good debt management represents that the borrower is no longer holding unnecessary loans (bad debts) and is committed to paying the loans as well as creating assets for financial stability.
Debt management starts with recognizing good and bad debts.
After that, you need to set a clearly defined financial plan with a budget for your necessary income and expenditures.
If you can do this, this is the time to follow your budget and make room for additional savings.
Well, what would you do with the additional savings?
You can either invest or pay off some of your loans.
Here comes the secondary theory. If you are up to repaying the loans, you need to choose which loan should you pay first.
If your loans continuously give you mental pressure, then the debt snowball method can help you a lot. The snowball method guides you to reduce the number of debts by paying the smallest one first.
There is another method we can debt avalanche theory that guides you to repay the most costly loans first.
There are other options such as debt consolidation and taking debt counseling from the professional.
Remember, you need to know how smart people deal with their debt. If you do not, we are here to help you with professional services.
The bottom line
If you have multiple loan types, identifying the good and bad debts first is your first task.
After that, the way is straightforward. Save money, categorize loans, and quickly repay the loans giving you mental and financial pressure.
Good luck
