What is the difference between good and bad debt?

Debt can be an emotional subject but 'burying your head in the sand' won't help you manage your finances

Owing money on a credit card is considered bad debt because they carry high interest rates. Getty

Is having debt always a negative thing? Most people I speak to consider all debt bad – not just the credit card debt caused by overspending, but also when talking about personal loans, car loans or mortgages.

Is there such a thing as good debt? What is good debt and what is bad debt?

Good debt is often defined as money owed for something that can help build wealth or increase income over time, such as mortgages, student loans or a business loan. These usually carry low interest rates.

Bad debt, on the other hand, refers to facilities such as credit cards or other consumer debt that do little to improve your financial situation. Some consider debt to purchase depreciating assets such as cars as bad debt. Credit card debt carries very high interest rates and are also considered a form of bad debt.

But is it as simple as a combination of interest rates and purpose?

What about your feelings about debt and the emotional impact? Debt can be a very emotional subject. Like all money decisions and situations, our money mindset will play a significant part in what is deemed to be good or bad for each individual.

How do you know what your debt mindset is? Think about how you feel about having debt. How do you feel about others having debt? What language do you use when discussing debt, either your own or others? Most will have strong feelings either way.

When someone tells me about their debt, the most common phrase I hear is: “I am in debt.”

Quote
The phrase “drowning in debt” compounds this idea that debt is all-consuming and something that’s hard to overcome
Carol Glynn, founder of Conscious Finance Coaching

This tells me a lot about their debt mindset. Phrasing your debt situation in this way insinuates that a person is physically in something negative.

The phrase “drowning in debt” compounds this idea that debt is all-consuming and something that’s hard to overcome. It insinuates you are drowning or dying financially or worse, failing at life.

It is important to remember that debt is not physical and you cannot be “in it”.

I prefer to say, “I have debt”. It is not part of the person, nor part of their identity or self-worth. It’s something we have to manage and deal with that is separate from who we are and our physical being.

There is another consideration when deciding if a debt is good or bad for your financial health: your debt-to-income ratio, which measures the amount of debt a person has compared with their overall income.

It is an important metric when reviewing your financial health or when deciding to take out a new loan or mortgage. If your total monthly debt payments are $2,000 and your income is $5,000, then your debt-to-income ratio is 0.4 (2,000:5,000).

Calculating your debt-to-income ratio will help you to understand if you can afford to service your debt obligations and tells you how much of your income is consumed by your debt. It is also an important factor in determining if a mortgage provider will lend to you.

It is important to calculate this number when deciding to apply for a personal loan, mortgage or car loan.

Credit card debt forms part of this calculation – but remember that it is a firm example of bad debt.

It is always advisable to pay off credit card bills as quickly as possible, regardless of your debt-to-income ratio, as the effect of compounding interest and high interest rates means that it multiplies very quickly.

Credit card debt is often caused by unforeseen large expenses or emergencies such as medical or dental bills, appliances needing to be replaced or annual costs, such as car or medical insurance.

Having a “sink” fund and an emergency fund in place will help to prevent the need to use credit cards in cases of emergency or for large annual expenses.

Debt is often laden with shame, regret and anxiety. It is also the number one issue that people “bury their heads in the sand”.

If it is a major source of stress in your life, create a debt repayment plan and focus on clearing that stress from your life. However, I would also challenge you to think about whose ideals are driving these feelings.

Are they yours or someone else's? Maybe you were raised to believe all credit is good and so rely on credit cards and loans for all major purchases.

But without understanding the impact, are you now finding yourself with debt that you are struggling to maintain?

Or were you raised to believe all debt is bad and so perhaps, even unconsciously, you feel you are failing financially if you have a car loan, for example?

Remember, not all debt is bad and not all debt is good – but most importantly, having debt does not make you a bad person or a financial failure.

Carol Glynn is the founder of Conscious Finance Coaching

Updated: April 01, 2022, 4:00 AM
EDITOR'S PICKS