A key part of financial wellness is keeping debt under control.
Even though the word “debt” tends to carry a negative connotation, not all forms of debt are inherently bad. In fact, many financial experts often categorize debt into “good debt” and “bad debt.”
Good debt is something that will pay off in the long run by ultimately increasing your earning potential or wealth, while bad debt just adds to the deficit without providing any additional benefits.
Here is an overview of some of the most common forms of “good” debt and “bad” debt.
Good debt tends to carry low interest rates and serve as an investment in your future. A few types of debt that fall into the “good” category include:
- Student loans: A college or technical education can build your skill set and lead to a more specialized, higher-paying job. While some people might be able to pay for their education out of pocket or through scholarships, student loans are still one of the main ways to finance higher education. To make sure the return on investment is worth it (and ensure that student loans remain a form of “good debt”), you should aim to keep student loan debt below your expected annual salary in your first job after graduating. For example, if you expect to earn $50,000 a year based on your chosen career path and desired location, then don’t borrow more than $50,000 for your education.
- Mortgages: Homeownership and real estate investing enable you to build equity in a property, which means that most homes are assets that increase wealth. However, most people do not have enough cash in the bank to pay for a house in full, which is why they take on a mortgage. Mortgages are secured loans paid back over an extended period of time, often 20 or 30 years. To ensure affordability, financial experts recommend keeping mortgage debt payments below 28% of your gross monthly income. Learn more about the 4 C’s of mortgage lending.
- Small business loans: Entrepreneurs need capital to start their businesses. Like student loans, the purpose of small business loans is to make an investment that will ultimately increase a person’s income.
Keep in mind that too much debt – even the “good” kind – can spiral out of control if you take on too much of it. A good rule of thumb is to ensure your overall debt-to-income ratio is 36% or less, which means your monthly debt payments divided by your gross monthly income should not exceed 36%.
In general, bad debt is debt used to purchase items or services that depreciate in value or otherwise cause you to lose wealth. Some forms of “bad debt” include:
- Credit card debt: Credit cards carry high interest rates (often more than 20%), which means that the total price of an item you purchase with credit can be substantially higher than if you paid with cash. To keep credit card debt under control, use no more than 30% of your available credit. That means that if your card has a $10,000 credit limit, try not to carry a balance of more than $3,000. And of course, pay off your credit card bill in full each month to avoid accruing more interest or incurring late fees.
- Loans for trips and material items: The occasional shopping spree or vacation isn’t necessarily bad, but taking out loans in order to afford material items isn’t the wisest financial move. Items like clothes and electronics decrease in value immediately after purchase, so they should never be the reason for taking on debt.
Keep in mind, the dollar amount usually doesn’t impact whether the debt is good or bad. For example, a $100,000 mortgage may be considered good debt while $10,000 in credit card debt would be considered bad debt.
For more information about how to navigate debt, credit, and loans, explore our Tools for Teaching Financial Literacy.