Do you know the difference between good and bad debt?

Not all debt is created equal. As counterintuitive as it may sound, some debt can be good. While you may strive to live debt-free, that isn’t necessarily the rosy paradise of financial freedom that it’s made out to be. Certain types of debt can actually help your credit in the long run.

Of course, the flip side of this is the harmful debt that can overwhelm you and lead to bankruptcy. Though debt relief is an option, it’s never appealing to have to consider rebuilding your credit due to bad debt. Bankruptcy can impact your credit for seven to 10 years, and even debt settlement or debt management can impact your credit scores.

Knowing the difference between good debt and bad can help you manage not only your debt, but also your credit.

Good debt

Let’s start with the good news. Some debt is good and much of it comes from very common sources. In general, good debt is debt you manage well and offers long-term financial gain. Good debt often also comes with a lower interest rate. This makes it possible to increase your net worth over time by paying off the debt and gaining something of greater value in the process.

Here are a few examples of good debt:

• Startup capital for a small business: Starting your own business isn’t cheap, but has the potential to be extremely profitable. Often, people need to borrow some money to get their business off the ground. This can feel risky and scary, but the leap can be worth the investment. If you run your business well and manage to grow it, that initial debt from starting out can be paid off comfortably and possibly ahead of schedule.
• Loans for school: For some, student loans have become the boogeyman of the modern era, but that debt may not be as dire as it sounds. Student loan debt means you probably have a degree and that alone can have a huge impact on your future earning potential. The Bureau of Labor Statistics consistently finds that more education typically means more earnings potential. In 2017, the median weekly earnings for someone with no college education was less than $750. Those with even an associates degree earned well over $750 per week; those with a bachelor’s degree surpassed $1,000 per week.
• Home mortgages: Real estate can be an extremely valuable investment. Real estate potentially gains value over time and may even be a tax deductible investment. However, a home mortgage comes with risks (think back to the 2008 recession when many home foreclosures happened). That’s why it’s usually best to have a down payment of at least 20%, that you’ve secured a loan with the lowest possible interest rate you can qualify for, and buy a home well within your means. This will allow you to have a little extra for regular maintenance, taxes and other costs that come with home ownership.

Bad debt

Now that we’ve talked about the good, let’s look at the bad. Many types of debt are bad and can harm your finances today and your credit for years to come. If things get so severe that you have to file for bankruptcy or need to enter into debt resolution, it may take years to rebuild your credit score.

Here are some examples:

• Credit card debt: This may be the most obvious one, but it can’t be overstated – credit card debt is bad news. If you’re carrying debt from month to month, you already know the interest rates can be sky high. Many people end up trapped in a cycle of debt they just can’t seem to pay off. That’s why it’s best to pay off your credit card balances every month if you possibly can.
• Payday loans: Unlike a student loan that invests in your future, a payday loan is a short-term stopgap solution that can exacerbate the problems you already have. Plus, as with credit cards, the interest rates are cringe-worthy. Some can even hit a staggering 300%, making it almost impossible to pay back the loan and damaging your finances in the long-term.
• Car loans: This one isn’t as clear cut as some of the others. On one hand, cars instantly start to lose value, so unlike investing in a home, you can’t expect to ever come out ahead with a car loan. That said, most people need a mode of transportation and can’t rely on public services like the bus or subway, while others need a vehicle for their livelihood. Purchasing a car that is within your means and getting a loan with the best rates you can qualify for help to ensure you don’t fall into a bad debt trap.