How Debt Works

By: Dave Roos

Good Debt vs. Bad Debt

A woman and her son walk past a bank's car loan poster in Jakarta.

While it's possible to live completely debt-free, it's not necessarily smart. Very few people earn enough money to pay cash for life's most important purchases: a home, a car or a college education. The most important consideration when buying on credit or taking out a loan is whether the debt incurred is good debt or bad debt.

Good debt is an investment that will grow in value or generate long-term income. Taking out student loans to pay for a college education is the perfect example of good debt. First of all, student loans typically have a very low interest rate compared to other types of debt. Secondly, a college education increases your value as an employee and raises your potential future income.


Taking out a mortgage to buy a home is usually considered good debt as well. Like student loans, home mortgages generally have lower interest rates than other debt, plus that interest is tax deductible. Even though mortgages are long-term loans (30 years in many cases), those relatively low monthly payments allow you to keep the rest of your money free for investments and emergencies. The ideal situation would be that your home increases in market value over time, enough to cancel out the interest you've paid over that same period.

An auto loan is another example of good debt, particularly if the vehicle is essential to doing business. Unlike homes, cars and trucks lose value over time, so it's in the buyer's best interest to pay as much as possible up front so as not to spend too much on high-interest monthly payments.

Good debt can also simply be low-interest debt. Home equity loans are usually considered good debt (or at least "better" debt), because their interest rates are lower than other types of debt, like auto loans or credit cards. With a home equity loan, the lending institution uses your home as collateral. The amount and interest rate of the loan depends on the appraised value of the house. While it may seem smart to consolidate other debts under a lower-interest home equity loan, carefully consider whether or not you can really make the payments. If not, you could end up losing your home.

Bad debt is debt incurred to purchase things that quickly lose their value and do not generate long-term income. Bad debt is also debt that carries a high interest rate, like credit card debt. The general rule to avoid bad debt is: If you can't afford it and you don't need it, don't buy it. If you buy a fancy, $200 pair of shoes on your credit card, but can't pay the balance on your card for years, those shoes will eventually cost you over $250, and by then they'll be out of style.

Payday loans or cash advance loans are some of the worst kinds of debt. In a payday loan, the borrower writes a personal check to the lender for the amount he wants to borrow, plus a fee. Then he has until his next payday to pay back the loan amount, plus the original fee and any interest incurred over that time period. Interest rates for payday loans are astronomical, starting at 300 percent annually [source: FTC]. And if you fail to pay back the amount by your next payday, you incur yet another processing fee to "roll over" the loan.

Now let's talk about some of the most effective ways to get out of debt.