Good debt vs. bad debt: What's the difference?

Good debt and bad debt is determined, in part, by whether your financial situation is set up to take it on.

Debt is a common part of American life. U.S. household debt reached $16.9 trillion in Q4 2022.¹  But how do you differentiate between debt that will help you move toward your financial goals and debt that will set you back?

What is good debt?

Good debt can be defined as money you borrow for something that has the potential to increase in value or expand your potential income. For example, a mortgage may help you buy a home that can appreciate. Student loans may help you increase your future income. Good debt is often considered an investment.

What is bad debt?

Bad debt can be defined as money you borrow for something that you quickly consume, depreciates in value or doesn’t help you make progress toward your financial goals. The best example is high-interest credit card debt, especially if you can’t pay off your balance each month.

How to avoid bad debt

Since not all debt is the same, these questions can help you determine whether you’re able to manage the debt you’re considering taking on.  

1.  What's your debt-to-income ratio?

Your debt-to-income ratio is calculated by taking your monthly debt payments (car, mortgage/rent, credit card, loans, etc.) and dividing that number by your gross monthly income.

• Generally, a debt-to-income ratio below 36% indicates a healthy balance sheet. If that’s the case, you may be able to manage taking on more debt. 

• A debt-to-income ratio above 36% could indicate added risk. You may have a harder time repaying the debt if you face an unexpected financial challenge. You may want to reconsider taking on additional debt. 

2.  How does the debt fit into your overall financial plan? 

• If you have a sense of how the debt will impact your other expenses, income, and savings and feel you can manage the debt, you likely have the information you need to move ahead. 
  

• If you haven’t fully considered how debt fits into your financial plan or don't have a plan to pay it off, it may be wise to create an overall financial strategy. Consider the different affects taking on debt can have on your finances.

3.  What are the specifics of the debt you’re considering?  

• It’s possible that you can borrow too much to pay for a mortgage or college education, which can quickly turn good debt into bad debt if you don’t have a plan to pay it off. Carrying too much debt can put you in a precarious financial position. Make sure your debt is always working for you and not the other way around.
• Finding an interest rate that’s a fraction of a percent lower can save you thousands of dollars over the course of a loan. Research interest rates to see what your options are.
• Some investors have benefited from using low-interest debt to purchase assets such as stocks that could earn a higher return. However, all investments have a risk of declining in value, which means there’s a chance you could lose money. Talk to a financial professional to review your options.
  
• A growing business might use debt to finance the purchase of a new building, or an investor may buy a rental property and use the rental income to help repay the debt. It’s important to consider the risk of a downturn that could make it harder to cover the debt payments. Talk to a financial professional to help determine what’s best for you.
  

Using debt strategically can help you work toward your financial goals. Read how to use debt to build wealth.