Good debt vs. bad debt: What’s the difference and why it matters for your financial health

In the world of personal finance, "debt" has a negative perception. However, not all debt is necessarily destructive for you. The answer is a bit more involved; some forms of borrowing can actually create wealth while others pose a more stealth risk to your financial health.

Reducing your chance of financial stress in the long run and making informed decisions about borrowing starts with understanding good debt vs bad debt.

Understanding debt

Simply put, in essence debt is money that is borrowed, which you pledge to pay back over a period, usually with interest. Whether this borrowed money is good debt or bad debt, it depends on how it is used and any terms attached to it.

What is good debt?

Good debt is borrowing money to purchase something that can either appreciate in value, or provide some ongoing income. It is an investment in your future.

Examples of good debt:

• Education loans: The increased income and job opportunities that often result from post-secondary education can be a great investment.
• Home loans: Most real estate appreciates over time and offers a tax advantage.
• Business loans: These are used for the purpose of creating or expanding a venture that could earn profit.

Why is it considered good?

1. There are many options, compared to other credit forms, to create new wealth.
2. Reasonable interest rates.
3. Tax deductions on interest in some cases.
4. Enhances your credit history if paid on time.

What is bad debt?

Bad debt refers to borrowing money for assets that depreciate rapidly or have little long-term benefits. Typically, bad debt has no financial returns and high interest rates.

Examples of bad debt:

• Credit card: Credit card debt for luxury purchases.
• Unsecured personal loans: Taken out for lifestyle or vacation improvements.
• Auto loans: Where the asset fully depreciates before the loan is paid off.

Why is it considered bad?

1. Carries high interest with no return.
2. Doesn't produce cash flow.
3. Could spiral into further debt if not maintained properly.
4. Could negatively affect your credit score.

Key differences between good debt vs. bad debt

Is all debt bad?

A lot of people wrongly think that the best thing to do is avoid debt altogether. However, smart debt can accelerate financial growth, generate opportunities and build credit. The essential thing is to determine if the debt helps to reach your goals or is simply for short-term gain.

How to use debt wisely?

• Only borrow what you can actually afford.
• Understand the interest, fees and costs of borrowing.
• Prioritise need over want.
• Keep your credit utilisation low.
• Paying bills on time will start building your credit history.

In conclusion, while bad debt may become a liability if not handled well, good debt, when used wisely, can be a pathway to financially empowered consumers. Financial literacy, reasonable debt, and frugal spending can free the person from bad debt. Getting borrowing to 'work for you' begins with understanding the fine distinctions between good debt and bad debt.

Disclaimer:Mint has a tie-up with fin-techs for providing credit, you will need to share your information if you apply. These tie-ups do not influence our editorial content. This article only intends to educate and spread awareness about credit needs like loans, credit cards and credit score. Mint does not promote or encourage taking credit as it comes with a set of risks such as high interest rates, hidden charges, etc. We advise investors to discuss with certified experts before taking any credit.