Good Debt vs Bad Debt: Know the Difference

"All debt is bad" is a popular but oversimplified rule. The truth is more useful: some debt builds wealth, some debt destroys it, and being able to tell them apart is one of the more important financial skills you can develop. Here's the framework.

The two questions that define good debt

Debt is "good" if it satisfies both of these:

1. Does it produce something more valuable than the interest costs? An education that increases your lifetime earnings, a house that builds equity, a business loan that funds a profitable venture.
2. Is the interest rate low enough that the math works? A 4% mortgage on an appreciating asset is different from a 22% credit card on a depreciating one.

If both are true, it's good debt, or at least defensible debt. If either is false, it's bad debt.

Examples of typically good debt

• Mortgages on a home you plan to live in for 7+ years. Interest rate is usually low, the underlying asset (often) appreciates, and the alternative (renting forever) has its own costs.
• Federal student loans for a degree with a clear earnings premium. Engineering, nursing, accounting, computer science, the lifetime ROI is usually massive.
• Business loans when the business has a clear path to profitability and the loan terms are reasonable.
• 0% promotional financing on something you would have bought anyway and can pay off before the promo ends.

Examples of typically bad debt

• Credit card balances carried month to month. 20%+ APR on consumer goods. Catastrophic.
• Payday loans. 400%+ effective APR. Designed to trap.
• Auto loans on luxury cars beyond your means. Cars depreciate fast, the interest rate is meaningful, and you're financing a status symbol.
• Buy-now-pay-later on impulse purchases. The whole product is designed to make you spend more than you would with cash.
• Private student loans for low-ROI degrees with no clear earnings premium.
• Personal loans for vacations, weddings, or other non-investment expenses.

The grey area

A lot of debt sits in between. It's good or bad depending on context.

• Auto loan on a reasonable car at a low rate. Necessary if you need a car for work, fine if the rate is below ~5% and the car is reliable.
• Student loans for an expensive degree. Worth it for a 25-year-old going into medicine. Less worth it for a 25-year-old going into a low-paying field.
• Mortgage on a house you might not stay in. Closing costs and selling costs eat any equity if you move within 3-4 years.
• Investment property leverage. Brilliant when the rental market is strong and you can manage tenants. Disastrous when neither is true.

The grey area is where you have to actually think. There's no shortcut.

The honest test

For any debt you're considering, ask:

1. What does this debt buy me?
2. Is the thing I'm buying worth more than the total interest I'll pay?
3. What happens if my situation changes, job loss, illness, market crash?
4. What's the worst-case outcome, and can I survive it?

If the answers feel comfortable, the debt might be a tool. If they make you anxious, it's probably a trap.

The single rule that matters

Even "good" debt is risk. Even mortgages have foreclosed on responsible families during recessions. The single rule that protects you: never take on debt you can't service if your income drops by 30%.

This rule eliminates almost all bad debt automatically. Stretching to buy a house at the limit of what you "qualify for" violates the rule. Taking on student loans whose payments will eat 40% of your starting salary violates the rule. Financing a car payment that's bigger than your rent violates the rule.

Good debt, used carefully, is a wealth-building tool. Bad debt, used routinely, is a wealth-destroying trap. Most people don't know the difference. You now do.