What’s the Difference Between Good Debt vs. Bad Debt?

Tom Gilmour is a senior director of Planning Experience Integration for Northwestern Mutual.

If you grew up being told to avoid debt at all costs, then you might consider all debt to be “bad.” But most of us aren’t able to go our entire lives without having to borrow money at some point.

While some types of debt are clearly bad for your financial health, other kinds can actually be beneficial in the long run because they help you achieve goals that would have been difficult—if not impossible—to achieve otherwise: Goals like buying a home, purchasing a vehicle, and even attending college.

Below, we explore the differences between good debt vs. bad debt to help you understand how each can affect your finances.

What is good debt?

Good debt is any kind of debt that helps you reach an important financial goal. Typically, it will have a lower interest rate than bad debt. Good debt can be viewed as an investment in the sense that whatever it is that you're borrowing for is ultimately intended to help you improve your financial situation.

Some examples of good debt include:

Student loans

Student loans are commonly referred to as good debt, due to two main reasons.

First, student loans (particularly federal student loans) tend to come with a low interest rate. For undergraduate students borrowing federal student loans in 2024, the interest rate is currently 6.53 percent.

Second, student loans make a college education possible for millions of Americans. And because completing college increases the potential for you to earn more money over the course of your career, they can be viewed as an investment in your financial future. According to the Bureau of Labor Statistics (BLS), the average worker with a bachelor’s degree earns $1,493 per week, or $77,636 per year. That’s $30,888 more per year than someone with only a high school diploma. Over the course of a 40 year career, that means the average college graduate earns nearly $1.25 million more than a high school graduate.

But student loans still weigh heavily on a lot of graduates, so it’s important that student borrowers try not to take out more than they can realistically repay. Private student loan companies may also charge you a higher interest rate than what the federal government offers.

A mortgage

Buying a home is going to be one of the biggest financial decisions you’ll ever make—and it’s certainly not a purchase most people can pay for using cash. Taking out a mortgage is what makes homeownership possible for the vast majority of people.

Mortgages also come with a few key financial benefits. Similar to student loans, they have generally low interest rates. A mortgage can also help reduce your tax liability, thanks to the mortgage interest deduction. Plus, as you make mortgage payments, you’re increasing your equity in your home, which helps your net worth grow over time.

It is, however, possible to finance more home than you can actually afford. What that means really depends on each individual’s circumstances, but generally, many lenders may use the 28/36 guideline when assessing borrowers for a loan. This means they prefer that a borrower’s housing costs not exceed 28 percent of their gross income, and their total debt (including mortgage payments plus other debts) not exceed 36 percent.

What is bad debt?

Bad debt typically provides no value back to you. In addition, the purchases you make will likely lose value over time, and the interest rate you are charged will be high rates.

Some examples of bad debt include:

Credit cards

When used correctly, credit cards can be an easy and convenient way to make purchases while potentially earning rewards. The moment you find yourself carrying a balance from month to month, however, is when it can cross the threshold into bad-debt territory.

What makes carrying a credit card balance so bad for your finances? The high interest rates. The average credit card in the U.S. carries an annual percentage rate of about 21.5 percent as of July 2024—and it can go much higher for borrowers with low credit scores. When you carry a balance, that interest means you’ll end up paying more—often a lot more—than what you were charged, with little to no investment to show for it.

That’s why it’s generally a good idea to avoid using credit cards unless you are sure you can always pay off your balance in full each month. If you currently have any credit card debt, you’ll want to make a plan to pay it off as quickly as possible.

Payday loans

Payday loans are an extreme example of bad debt. That’s because the interest rate on a payday loan can go as high as 700 percent in some states, and lenders may impose extremely aggressive repayment schedules—typically requiring repayment on your next payday (hence the name)

This can result in borrowers failing to repay their loans on time and being stuck with fees and interest accrual that compounds over time and is extremely difficult to pay off once you’ve missed even just one payment.

The gray area

Not all debt can be easily categorized as good or bad debt. Certain types of loans may have characteristics of both, making it really important that you understand the pros and cons of borrowing before you sign on the dotted line.

Auto loans, for instance, can be a gray area. An auto loan helps you purchase a vehicle that you need to go to work, complete everyday tasks or take care of your family—and their interest rates are typically low. But when you purchase a new car, the vehicle can lose as much as 10 percent of its value as soon as you drive it off the lot—and as much as 20 percent within the first year you own it. Plus, you may end up financing more car than you can afford, which can be detrimental to your finances.

How to prevent good debt from turning into bad debt

What's important to remember is that all debt—even good debt like student loans or a mortgage—has the potential to become bad debt if it’s not managed responsibly. Your financial advisor can help you assess how much debt you can reasonably take on and work with you on strategies for managing it so that your financial health stays intact.

Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP^®, CERTIFIED FINANCIAL PLANNER^®, and CFP^® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.