Dear Lifehacker, I keep seeing certain types of debt (mortgages, student loans) referred to as “good” debt, whereas other types (credit card debt, for example) are referred to as “bad” debt. What does that mean? What makes a certain type of debt “good” and another type “bad?” Thanks, Anon
Good question, Anonymous!
This is what individual experts have to say about an issue that affects each person differently – if you want personalised advice, we recommend you see a financial planner.
Good Debt vs Bad Debt
One of the primary differences between “good” and “bad” debt is the interest rate. Credit cards, for example, have high rates compared to other financial products, like some car loans or bank loans. If you don’t pay off your credit card bill each month, it can be easy for the balance to get away from you as the interest accrues.
A form of “good” debt, on the other hand, is a mortgage.
“These types of loans have fixed monthly payments that not only prevent interest from adding to the loan balance, but also help borrowers pay down portions of their debt each month,” says Dock David Treece, a financial analyst at FitSmallBusiness.com. Having this type of debt is likely to have a positive impact on your credit history, whereas credit card debt can hurt future loan approvals.
But it’s not all about the interest rate. Another way to tell if it’s “good” is how it’s secured. Secured debt is tied to collateral, whereas unsecured debt (like credit card balances, payday loans and medical bills) is not.
“In truth, this is a big reason why the interest rates are so much higher,” says Treece.
If you fall behind on credit card debt, for example, the lender may hire a debt collector or ask a court to garnish your wages until you’re caught up on payments. Again, this will be reflected in your credit report.
“Good” debt is usually secured by houses, cars or some other tangible asset which can be repossessed if you fall behind on payments. Basically, if it increases your net worth, it’s “good” debt. If it lowers your net worth, it’s “bad” (car loans could go either way).
“A major consideration that makes some debt ‘good’ debt is because it represents an investment in earning power or an asset that will increase in value over time,” says Treece. Real estate tends to appreciates over time, and HECS-HELP loans increases a person’s earning capacity.
If you have some extra money, it will be most helpful to your bottom line to prioritise paying off the high-interest, “bad” debt. That said, many people find success with the “snowball/” method, that prioritises the smallest debt and then builds up to the larger debts. It’s by no means a one-size-fits-all situation – find a debt repayment plan that works for you.