Good Debt vs Bad Debt

Thin Lines, Gray Areas, Blacks & Whites

Tichaona Zemura
January 22, 2025 • Estimated Reading Time: 8 minutes

What Is Bad Debt?

Bad debt refers to borrowing money for purchases that:

Depreciate in value or don’t retain their worth over time.
Don’t generate income or improve your financial position.
Have high interest rates, making them costly to carry.

Examples of Bad Debt

1. Credit Card Debt for Non-Essential Spending

Why It’s Bad: High-interest rates (typically 15-25% or more) make it expensive to carry a balance. Using credit cards for discretionary items like vacations, dining out, or luxury goods results in paying much more than the original cost.
Example: If you charge £2,000 for a vacation on a credit card with a 20% APR and make only the minimum payment (2% of the balance which is about £40):
- Time to Pay Off: It would take approximately 20.8 years (or about 21 years).
- Total Paid: You would pay a total of $7,209.97 over the repayment period.
- Total Interest Paid: You would pay $5,209.97 in interest alone, more than double the original vacation cost.
This highlights the dangers of making only minimum payments on credit card debt, especially with high interest rates. It’s a costly trap to avoid!

Annual Percentage Rate (APR)

Definition: The annual cost of borrowing money, expressed as a percentage. It includes the nominal interest rate plus certain fees or costs, such as loan origination fees.

Usage: Commonly used for loans (e.g., mortgages, credit cards, auto loans).

Example: A credit card with a 20% APR means you’ll pay approximately £200 in interest for every £1,000 balance carried over a year, assuming no additional fees.

2. Payday Loans

Why It’s Bad: Payday loans often carry interest rates of 300-400% APR, trapping borrowers in a cycle of high-cost borrowing. They don’t improve financial standing and are hard to escape.
Example: Borrowing $500 for an emergency and paying back $625 two weeks later is a financial loss with no long-term benefit.

3. Loans for Luxury Vehicles

Why It’s Bad: Cars depreciate quickly (up to 20-30% in the first year). Borrowing to buy a car beyond your means strains your budget without providing financial returns.
Example: Financing a $50,000 luxury car at a 5% interest rate results in $6,000+ in interest over five years. Meanwhile, the car’s value may drop to $25,000 during that period.

4. Personal Loans for Unnecessary Purchases

Why It’s Bad: Personal loans with no clear financial return—for things like vacations, weddings, or electronics—lead to long-term financial strain without improving your wealth or income.
Example: Taking a £10,000 loan at 10% interest to pay for a wedding adds $3,000+ in interest over 5 years, while the expense has no long-term value.

5. Buy-Now-Pay-Later (BNPL) Purchases

Why It’s Bad: BNPL plans encourage spending on non-essentials and can result in multiple loans with hidden fees or penalties for late payments.
Example: Financing a £1,000 smartphone with BNPL might lead to high fees if you miss payments, effectively turning a convenience into a costly debt.

6. Cosmetic or Elective Surgery Loans

Why It’s Bad: Elective procedures rarely increase financial value, and borrowing to pay for them can leave you with high-interest debt for a depreciating benefit.
Example: Taking out a £5,000 loan for cosmetic surgery at 12% interest may result in years of repayments for a non-essential expense.

7. Rent-to-Own Financing

Why It’s Bad: These arrangements often result in paying 2-3 times the original value of items like furniture or appliances due to high fees and interest.
Example: Renting a £1,000 TV for £50 a month over 36 months ends up costing £1,800—a poor financial tradeoff.

What Is Good Debt?

Good debt is borrowing money for assets or investments that:

Appreciate in value or retain their worth.
Generate income or help improve your financial situation.
Typically come with lower interest rates and manageable terms.

Examples of Good Debt

1. Mortgage Loans

Why It’s Good: Real estate often appreciates over time. A mortgage lets you build equity while paying for a necessity (housing).
Example: Buying a home for $200,000 with a 4% mortgage can lead to significant appreciation over 10-30 years, potentially increasing your net worth.

There is a fair argument, why a Mortgage could be viewed as a bad loan by some who are advanced in their financial literacy. Reasons are:

1. High Total Interest Paid Over Time

Mortgages often come with long repayment periods (15-30 years), resulting in borrowers paying a substantial amount in interest. For example, on a $300,000 loan at 5% interest over 30 years, the total interest could exceed $279,000—almost doubling the cost of the home.

2. Market Risk and Property Depreciation

Real estate values can fluctuate. If the market crashes, the value of the home could drop below the loan balance (negative equity), leaving the borrower with a financial loss.

3. Loss of Financial Flexibility

A mortgage ties up a significant portion of monthly income, reducing flexibility for other investments or savings opportunities. This financial commitment could be especially burdensome during periods of unemployment or unexpected expenses.

4. Opportunity Cost

The money used for a down payment and monthly payments could potentially yield higher returns if invested elsewhere, such as in stocks, bonds, or starting a business.

5. Commitment to a Single Location

A mortgage locks a borrower into a specific property, which may hinder mobility. If job opportunities or personal circumstances require relocation, selling the property or managing rental arrangements can be complex and costly.

6. Foreclosure Risk

If the borrower encounters financial difficulties and cannot make payments, they risk losing their home and damaging their credit, creating long-term financial and emotional strain.

2. Student Loans

Why It’s Good: Borrowing to invest in education can lead to higher lifetime earnings. Federal student loans often have lower interest rates and flexible repayment options.
Example: A $30,000 loan for a degree that increases earning potential by $15,000 annually pays for itself within 2 years.

Like Mortgages, Student Loans can alternatively be viewed as bad debts

1. High Total Cost of Borrowing

- Student loans, especially those with long repayment terms, can result in significantly more money paid than the original amount borrowed due to accrued interest. For example, a $50,000 loan at 6% interest repaid over 20 years could cost over $86,000 in total.

2. No Guaranteed Return On Investment

- A degree does not guarantee a high-paying job or career advancement. Many graduates struggle to find jobs in their field or face underemployment, leaving them with debt that outweighs the benefits of their education.

3. Limited Financial Freedom

- Monthly payments on student loans can be burdensome, restricting the ability to save, invest, or make major purchases such as a home. This can delay wealth-building activities for years or decades.

4. Non-Dischargeability in Bankruptcy

- Unlike many other types of debt, student loans are notoriously difficult to discharge in bankruptcy, meaning borrowers are stuck with the debt regardless of their financial circumstances.

5. Compounding Interest During Deferment

- For loans that accrue interest during deferment periods, the total loan balance can grow significantly, making repayment even more challenging after graduation.

6. Mismatch of Degree Cost vs. Earning Potential

- Many students take out large loans to pursue degrees in fields with low earning potential, making it difficult to repay the debt. This is especially problematic for students who do not complete their degrees.

3. Small Business Loans

Why It’s Good: These loans provide capital to start or grow a business, potentially leading to increased income and long-term wealth.
Example: Borrowing $50,000 to open a profitable business that generates $10,000 monthly revenue within a year you would make your investment back.

4. Low-Interest Personal Loans for Debt Consolidation

Why It’s Good: Replacing high-interest debt with a single, lower-interest loan can save money and simplify repayment.
Example: Consolidating $10,000 of credit card debt (20% APR) into a personal loan at 8% APR saves over $1,000 annually in interest.

5. Investing with Leverage

Why It’s Good: Carefully using debt to invest in appreciating assets, like stocks or real estate, can amplify returns (though this comes with risk).
Example: Taking a $100,000 loan at 5% to buy a property that generates $12,000 annually in rental income plus appreciation.

Key Differences Between Good and Bad Debt

Aspect	Good Debt	Bad Debt
Purpose	Investment in appreciating assets	Non-essential, depreciating purchases
Interest Rates	Typically lower	Often higher
Financial Impact	Helps build wealth or income	Drains resources, increases stress
Value Over Time	Asset retains or grows in value	Asset loses value rapidly

How to Evaluate Debt

Ask These Questions:
- Will this debt help me build wealth or improve my financial position?
- Does the purchase retain or grow in value over time?
- Can I afford the payments without compromising essential needs?
Avoid Debt That:
- Has high interest rates and fees.
- Funds unnecessary lifestyle upgrades or depreciating assets.
- Creates stress or prevents saving and investing.

By distinguishing between good and bad debt, you can make smarter borrowing decisions and set yourself up for long-term financial success.

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