We live in a world where debt is a regular occurrence, and managing debt effectively to build a strong credit history is important for all consumers.
All debt is not created equal; there is good debt, and there is bad debt. It is important to remember that debt and its categorization (good vs. bad) is a matter of your personal situation and may not be the same for everyone else.
The University of Alabama’s Dr. Melissa Wilmarth explains the difference between the two.
Good Debt:
- Good debt can help you increase your wealth in the long-term.
- Good debt can be characterized as being secured debt (meaning it has an asset backing as collateral), used to purchase assets that will have an increase in value, may generate tax benefits and, generally, has a low interest rate.
- Examples of good debt may include: student loans, mortgages and business loans.
Bad Debt
- Bad debt occurs when debt is being used to purchase something that immediately goes down in value.
- Bad debt can be characterized as being unsecured debt (meaning there is not an asset backing as collateral to the debt), not generating income in the long run, in general carries high interest rates, and/or does not produce tax benefits.
- Examples of bad debt include: credit cards, payday loans, pawn shops, and loans from your retirement accounts and life insurance.
When the Good Turns Bad
It is important to be aware that good debt may not stay good debt, it may turn bad: Be aware of these characteristics that could turn good debt into bad debt:
- Interest rate is variable or higher than is available elsewhere in the market.
- Ignoring tax breaks from your debt.
- Timing of your debt. Manage your debt so that you are not in debt during fixed-income times, like retirement.
- Debt-to-income ratio is greater than 36 percent (Debt to income ratio: the amount of debt you owe each month divided by your monthly income).
Wilmarth is an assistant professor in the department of consumer sciences at UA’s College of Human Environmental Sciences.