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Good Debt vs. Bad Debt

4 min read

Not all debt is created equal. Some debt builds wealth over time — it funds assets that appreciate or generate income. Other debt funds consumption and erodes wealth through compounding interest. The distinction matters because how you treat debt should depend on which kind it is.

The Core Framework

Good debt meets three criteria: it finances an asset likely to appreciate or generate income, carries a reasonable interest rate relative to the expected return, and the terms are manageable within your cash flow. Think of it as leverage — borrowing to build.

Bad debt finances consumption. It carries high interest rates, funds depreciating assets or experiences, and compounds against you. Bad debt is not leverage; it's a drag.

Examples of Good Debt

Mortgages. A fixed-rate mortgage on a primary residence is the classic example. Reason: real estate historically appreciates ~3–4% annually, mortgage interest may be tax-deductible, and you're paying for shelter you'd need anyway. A 30-year fixed mortgage at 6.5% isn't cheap by recent standards, but if the alternative is renting forever and building zero equity, the math still favors buying — provided you stay put for 5+ years.

Student loans (within reason). A $30,000 federal loan for a nursing degree that leads to a $75,000 starting salary passes the test. A $120,000 private loan for a low-earning graduate degree does not. The guideline: total student debt should not exceed your expected first-year salary. Exceed that, and the debt-to-income ratio becomes genuinely burdensome for decades.

Small business loans. Borrowing $50,000 to buy equipment that generates $15,000/year in additional profit is productive leverage. The return on the borrowed capital exceeds the cost of borrowing. This is how businesses (and wealthy individuals) use debt — as a tool, not a crutch.

Margin loans (advanced users only). Borrowing against a taxable brokerage portfolio at rates around 6–8% to fund a short-term bridge — say, buying a house before selling the old one. The risk is that securities can decline and trigger a margin call. Not for beginners.

Examples of Bad Debt

Credit card balances. The average credit card APR is ~22%. At 22%, a $5,000 balance that you pay $150/month toward takes over 4 years to clear and costs ~$2,600 in interest. Credit card debt compounds against you at rates that stock market returns can't reliably beat. This is the single most destructive form of household debt.

Payday loans. APRs routinely exceed 300%. These are not loans — they're traps. If you're considering one, explore credit union small-dollar loans, payment plans with creditors, or local assistance programs instead.

Car loans on depreciating assets. A car loses 20–30% of its value in year one and ~60% over five years. Borrowing at 7% to buy a depreciating asset means you're paying interest on something that's worth less every month. That said, a modest car loan at a low rate (sub-4%) on a reliable used car isn't "bad" in the same way credit card debt is — it's more like neutral debt, a necessary cost for transportation. The trouble starts when the loan term stretches past 60 months or the payment exceeds 10–15% of take-home pay.

Buy now, pay later (BNPL). Klarna, Afterpay, Affirm. These fragment one purchase into four interest-free payments, which sounds harmless. The danger is behavioral: BNPL normalizes spending money you don't have. When 5 separate BNPL plans each deduct $40 every two weeks, your paycheck leaks $400/month before you notice.

Warning Signs That "Good" Debt Has Turned Bad

The payment consumes more than 36% of gross income. Lenders use the 28/36 rule — housing shouldn't exceed 28% of gross income, total debt payments shouldn't exceed 36%. A mortgage that pushes total debt service to 40% means you're house-poor, even if the mortgage itself is "good" debt.

You're only paying minimums. Minimum payments on any debt — mortgage, student loans, credit cards — are designed to stretch the repayment period to the maximum. If you can't afford to pay more than the minimum, the debt is too large relative to your income.

You're borrowing to pay other debts. This is the spiral. Using one credit card to pay another, or taking a HELOC to pay credit cards without addressing the spending that caused the debt, is a flashing red light.

The asset isn't performing. If you borrowed $40,000 for a master's degree and your salary didn't budge, the debt was bad — you just didn't know it at the time. Sunk cost. Pay it off and move on.

A Repayment Order That Works

If you have multiple debts, prioritize this way:

  1. Build a $1,000 starter emergency fund so a small surprise doesn't add more debt.
  2. Pay minimums on everything to protect your credit score.
  3. Attack the highest-interest debt first (the avalanche method). Mathematically optimal.
  4. Alternatively, attack the smallest balance first (the snowball method). Psychologically motivating. Either works if you stick with it.
  5. Once high-interest debt (>8%) is gone, shift extra payments to tax-advantaged investing before paying low-interest debt (mortgage, sub-5% student loans) faster than required.

Debt is a tool. Like any tool, it's useful when wielded intentionally and dangerous when it wields you.

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