Good vs. bad debt: How to tell the difference
Debt can be your ally or your enemy.
- Fidelity Smart Money
- – 09/26/2022
- "Good debt" can help you increase your net worth over time or generate future income.
- "Bad debt" does not help your net worth increase or generate future income, and may have a high interest rate.
Debt may be a word that almost no one likes, but it's one many know well. The average American adult owes just over $93,000, according to a recent Experian consumer debt study.1
That number may give you sticker shock. But remember that debt isn't always high interest or fast multiplying or what people classify as "bad debt." In fact, certain kinds of loans are recognized by some as "good debt." Good debt is seen as a tool for building your financial future and, in the case of mortgages, attaining a piece of the American dream.
Here's how to tell the difference between good debt and bad debt, plus how to minimize any bad debt you may have.
What is good debt?
Good debt is generally considered any debt that may help you increase your net worth or generate future income. Importantly, it typically has a low interest or annual percentage rate (APR), which our experts say is normally under 6%.
Examples of good debt
While student loans can be a financial burden, taking on debt to pay for education is generally considered "good debt" because more education can raise your future income. The typical college graduate earns $500 more per week (or $26,000 a year) than someone with a high school diploma.2 College grads also have a lower rate of unemployment, according to the US Bureau of Labor Statistics.3 That leads to almost double average lifetime earnings, according to the Brookings Institute.4 That's why some consider student loans an investment in your future.
However, it's important to note that for student loan debt to be considered "good," it must meet a couple of criteria:
- Low interest rates. Lower interest rates on student loans helps make them easier to pay off in the future. Federal student loans often have these kinds of interest rates, but not all private student loans do. Be sure to carefully evaluate the terms on any student loan debt you take on.
- Helps your short-term and long-term career prospects. Having even a rough estimate of what your income could be after graduation and throughout your career can help put your student debt in the context of your future finances. Taking on extensive, higher-interest student loans to pay for a degree that may only lead to a salary comparable to what you could already make, for instance, might not be beneficial. In certain cases, understanding whether you may have access to employer benefits or government programs to pay down student loans can help you make a wise decision.
Have student loans and wondering how to pay them off? Visit Fidelity's student debt tool.
Home or real estate
Mortgages are a type of loan used to buy a house or real estate. Historically, they've been considered one of the safest forms of debt because they tend to have lower interest rates and they can help you build equity (think: gradual ownership of your home).
The equity Americans can build in their home is important for a few reasons:
- Home equity is the biggest asset most Americans have. Almost two-thirds of Americans have equity in a home, with the median value of that equity coming in at $150,000, according to the US Census Bureau.5
- Homes may appreciate, or gain, in value. Since 1991, home prices have risen an average of 290% or an average of 4.6% annually, according to the Federal Housing Finance Agency.6 As with any investment, though, past performance is no guarantee of future success, and a home may decrease in value, even below the amount you owe on a mortgage.
- If you need or choose to, you can borrow against the equity you've built in the form of a home equity loan or home equity line of credit (HELOC).
Be sure to do your homework before signing on any dotted line, especially for a mortgage, which can have a lot of variables. For example, you may be able to choose if your mortgage has a fixed or variable rate. Fixed-rate mortgages and variable-rate mortgages offer important tradeoffs—variable-rate mortgages are more complex and often offer lower initial rates but with the possibility of rate increases. If you're in the market, look over these 5 things any homebuyer should consider when shopping for a mortgage.
What is bad debt?
Bad debt is debt used to finance purchases that won't increase your net worth or future income. In some cases, the debt may be used to buy things that depreciate. Bad debt often has a high interest rate now or a variable rate that could become high in the future, meaning you'll likely end up paying a premium for purchases that are worth less over time.
Examples of bad debt
Credit cards make (over)spending easy because, psychologically, swiping is less painful than spending cash.7 But running up a credit card balance can create more pain later.
The average American has more than $5,000 of credit card debt, according to a 2021 study by Experian.8 To add insult to injury, credit cards usually have high APRs, sometimes well over 20%—making repayment costly. Then, because people often use credit to buy things that are quickly consumed, like food and clothing, they wind up with little to nothing to show for that debt.
How can you avoid this type of bad debt? Make a plan to pay down credit card debt you have today, then start treating your credit card like a debit card. Only use it for purchases that you could pay for with the money in your bank account. Creating and keeping a budget can also help your spending stay out of the red, and working to build an emergency fund of 3 to 6 months of expenses can help protect you from relying on credit cards in a pinch.
Other high-interest loans
Generally high-interest loans are those that have an interest rate or APR of 6% or higher, according to our experts. You may encounter them in the form of payday loans or certain personal loans. These loans may be difficult to pay back, which can make them even costlier as interest compounds and grows. For instance, over 3% of personal loan holders are more than 60 days late on payments, according to TransUnion.9
Because of their interest rates alone, these types of loans should only be used in emergencies when all other options are exhausted. To avoid having to rely on high-interest loans, you'll want to follow the same steps you would to tackle credit card debt. Pay down any existing high-interest loans you have and aim to get an emergency fund established as soon as possible to avoid taking out loans in the future.
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