The difference between a good debt and a bad debt depends on what a debt gets you in the long run
The debate on good debt vs bad debt is very wide on the Internet. And not everyone agrees on how those terms should be used for specific types of loans and credits. But there is a clear definitional line that separates good debt from bad, and it’s about what debt does for you in the long run.
This page explains how to separate good debt from bad, and what each means for your budget. We also explain how even good debt can turn bad and what to do when that happens.
Definition of good debt vs. bad debt
The defining line between good and bad is what a debt provides you in the long run. Good debt gives you something that benefits your life in general. You basically have something of value that you keep even after paying off the debt. On the contrary, bad debts do not give you long-term benefits. They only leave you a debt.
But that line can be a bit confusing. You may feel like you are getting something out of bad debt. For example, if you use a credit card to buy an HDTV, you get something of tangible value: the television. But the value of that property decreases significantly over time. It is not like a house, where the value of the property generally increases over time. That is why a mortgage is good debt.
Things get even more confusing when it comes to auto loans. The value of a new car depreciates quickly as soon as you take it off the lot. You will never be able to sell the car and get all the money you put into your car loan back. Therefore, you do not get something of long-term value. But a used car loan to finance a classic car purchase would be different because the value of the vehicle does not depreciate in the same way. Therefore, some auto loans can be considered good debt.
This chart provides a basic breakdown of which debts count as good and which as bad. We explain more about why each type of debt falls where it does.
Understand why certain debts are good or bad
A mortgage is always considered good debt A mortgage is always considered good debt. In fact, it is pretty much the best debt you can take on. That’s because property always has value, and that value generally increases over time. So buy a house this year with a 15-year mortgage. He pays off most of the mortgage and sells the house within 10 years. Not only will you get back the money you spent on debt, but it is also very likely that you will make a profit.
You can also think of it this way. A home is normally an owner’s greatest asset. Net worth is calculated by subtracting your total liabilities (that is, your debts) from your total assets. Outside of home marketing accidents, most people’s home values are higher than what they owe on their mortgages. Therefore, a home generally increases a person’s net worth. That is what makes it good debt.
Home Equity Loans and HELOC:-
Home Equity Loans and HELOC Unlike a first mortgage, a second or third mortgage is often considered bad debt. This includes home equity loans and home equity lines of credit (HELOC). You are basically borrowing against the value of your existing property. You decrease your net worth because you increase your liabilities without obtaining a new asset.
But there can be a gray area with home equity loans in some cases. The most common is using a home equity loan to renovate or make improvements to your home. Many improvements can significantly increase the value of your property. For example, let’s say you add a pool and outdoor patio to your single-family home. That increases the value of the property. Therefore, in this case, the home equity loan could be considered good debt.
On the other hand, there are uses of capital that are considered bad because nothing is obtained in the long term. For example, if you use a home equity loan to pay off credit card debt, then the home equity loan would be considered bad debt. You have leveraged an asset to simply convert unsecured credit card debt into secured mortgage debt. This creates a higher risk of foreclosure and lowers your net worth. So, in this case, the home loan would be bad debt.