Good Debt vs. Bad Debt: How to Tell the Difference Before You Borrow

Not all borrowing is the same, and knowing which kind helps you and which kind hurts you can save you years of stress and a lot of money.

What "good" and "bad" debt really mean

Debt is money you borrow now and promise to pay back later, usually with interest. Interest is the extra cost you pay for using someone else's money. It is often shown as an APR, or annual percentage rate, which is the yearly cost of the loan including many fees.

People often say some debt is "good" and some is "bad." Those labels are a shortcut, not a rule. A better way to think about it:

• Helpful debt pays for something that may grow in value or raise your income over time, at a cost you can handle.
• Harmful debt pays for things that lose value fast, carries a high cost, or has payments that squeeze your budget.

The same type of loan can land on either side. A home loan can be helpful for one family and crushing for another if the payment is too big. So the real question is not "what kind of debt is this?" but "does this debt move my life forward at a price I can afford?"

Debt that is often considered helpful

These kinds of borrowing are commonly called "good debt" because they may build something lasting. Each one still comes with real costs.

A mortgage. A mortgage is a loan to buy a home. Each payment may build equity, which is the part of the home you actually own. Over time, that equity can become a big part of a family's wealth. But a house that costs too much can leave little room for anything else, and home values can fall as well as rise.

Student loans. Education can open doors to higher pay. Federal Student Aid notes that interest on unsubsidized federal loans starts adding up from the date the money is paid out, which is why it urges students to borrow only what they need. A degree that leads to a steady career may be worth the cost. A large balance for a program that does not lead to work can follow you for decades.

A small business loan. Borrowing to start or grow a business can create income. It can also leave you owing money if the business does not work out, so many owners start small.

A reasonable car loan. Cars lose value quickly, so a car loan is not "good" in the wealth-building sense. Still, a modest, reliable car that gets you to work can protect your income. Borrowing a small amount for a basic car is very different from stretching for an expensive one.

Debt that is often considered harmful

These types of debt tend to cost a lot and give little lasting value back.

High-interest credit card balances. Credit cards are handy, and paying the full balance each month avoids interest. Carrying a balance month after month is where trouble starts. Card interest rates are usually much higher than rates on many other common loans, such as car loans, and interest builds on top of interest. Your statement includes a box showing how long payoff takes if you pay only the minimum, and it is often eye-opening.

Payday loans. A payday loan is a short-term, high-cost loan, usually due on your next payday. The Consumer Financial Protection Bureau (CFPB) says a fee of $15 per $100 borrowed is common, which works out to an APR of almost 400 percent for a two-week loan. A CFPB study found that four out of five payday loans were rolled over or renewed within 14 days, meaning many borrowers took a new loan to cover the old one.

Borrowing for wants that fade fast. Vacations, nights out, the newest phone or clothes bought on credit are often still being paid off long after the fun is over. That does not mean you can never enjoy these things. It means paying for them with money you already have usually costs less.

Loans with surprise terms. Watch out for loans with big fees, balloon payments (a large lump sum due at the end) or "deferred interest" deals, where all the interest can hit at once if you do not pay in full by a deadline.

Five questions to ask before you borrow

Before you sign anything, these questions can help you decide which side of the line a loan falls on.

1. Will this help me earn more, own more or keep my income steady? If the answer is no, consider whether you can save up instead.
2. What is the total cost? Look past the monthly payment. Multiply the payment by the number of months, then compare that to the price of the item.
3. Can I afford the payment if something goes wrong? Think about a job loss, a cut in hours or a surprise bill.
4. How does this change my debt-to-income ratio? The CFPB defines debt-to-income ratio, or DTI, as all your monthly debt payments divided by your gross monthly income (your pay before taxes). For example, $2,000 in monthly debt payments on $6,000 of monthly income is a DTI of about 33%. Lenders look at this number, and different lenders and loan types have different limits. A lower DTI usually means more breathing room.
5. Is there a cheaper option? A credit union loan, a payment plan with a doctor's office, or simply waiting and saving may cost far less.

Turning harmful debt into a plan

If you already carry costly debt, you are far from alone, and there are steps that can help.

• List every debt. Write down the balance, interest rate and minimum payment for each one. Seeing it all in one place takes away some of the fear.
• Stop adding to it. Consider putting cards away or removing them from online shopping accounts while you pay them down.
• Pick a payoff order. Some people pay the smallest balance first for quick wins. Others pay the highest interest rate first to save the most money. Either approach beats paying minimums forever.
• Look for a lower rate. Calling your card company to ask for a lower rate, or talking with a nonprofit credit counselor, may reduce your costs.
• Build a small cash cushion. Even a little money set aside can keep a flat tire from landing on a credit card.

Remember that "good" debt can turn bad if you borrow too much. A home, a degree or a car can all become a burden when the payments crowd out food, rent and savings.

This article is for education only and is not financial advice. Everyone's situation is different.