Why Good Debt Is a Good Thing — and What Debt You Should Have
Debt can be a good thing, as long as it’s pushing your finances forward.
Contributing Writer at Tally
October 5, 2021
Though so much focus is placed on paying off debt, consumer debt can have its pros, too. You can think about it as good debt and bad debt: Bad debt is the high-interest debt that drags down your bank account balance, possibly harms your credit score and reduces your net worth.
But what is good debt? We’ll cover the ins and outs of good debt, including traditionally good debt and some traditionally bad debts that can be good debts in certain conditions.
What is good debt?
Good debt can take many forms, but it’s categorized as any debt that can help build your income or net worth. Other financial benefits can also make debt good, such as building credit for future good-debt acquisition, like a home mortgage.
Let’s explore some examples of traditional good debt and debt that’s potentially good if used correctly.
Traditionally good debts
Good debt versus bad debt is nothing new, and some debts have always landed in the “good” category. We’ll look into these traditional examples of good debts below and how they can go bad.
Student loans are generally low-interest debts — if they’re federal student loans — and help expand the borrower’s earning potential through a college education. This checks key boxes in qualifying as good debt.
Student loan debt can become bad debt when payments aren’t made. Student loan debt is the second-largest American consumer debt after mortgages at more than $1.5 trillion in loans, and, on average, 15% of student loans are in default.
Then there’s the private student loan segment, which can have significantly higher interest rates — up to 12.99% versus up to 5.3% on federal student loans.
Because businesses are generally formed to help build net worth, business financing is traditionally a good debt. Whether it’s a loan to start a new business or expand an existing business, it’s usually a benefit.
Business loans can go bad — like when the business fails and can no longer afford the loan payments. Depending on the business structure, a defaulted business loan can significantly impact the business owner’s credit score and finances.
Home mortgages are the last of the traditionally good debt. A mortgage is good debt because homes generally appreciate, so the owner is constantly building equity and net worth while paying down the loan balance.
Like the others, there are times when mortgages go south, such as national financial crises. These can cause home values to plummet, leaving owners owing far more than the home is worth. Typically, these market fluctuations flatten out, but it can take years for them to normalize.
Other potentially good debts
Beyond the traditionally good debts, some traditionally bad debts can be good if used correctly, especially for younger folks looking to establish secure finances.
Let’s look at these types of debts and the fine line they walk between helpful and harmful to your finances.
It may sound surprising, but credit cards can be good debt if you use them the right way. The key way they can help is to build your credit in your younger years. They are a relatively easy debt to obtain early in life, and if you only charge what you know you can pay off each month, you’ll establish a positive payment history on your credit report without paying interest.
Your payment history makes up 35% of your FICO credit score, so this can play a huge role in your ability to get approved for traditionally good debt, like a mortgage, later.
It’s important to remember that credit cards can go sideways quickly. If you become too comfortable with swiping your credit card without monitoring your balance, it’s easy to suddenly find yourself in deep credit card debt and battling high interest rates.
Auto loans are also generally viewed poorly among experts because cars, by nature, depreciate unless they are collectible.
Cars tend to lose about 10% of their value in the first month of ownership and 20% overall in their first year. It’s not uncommon to be extremely upside down — you owe more on the loan than the car is worth — in the first few years of the loan. This is one reason many experts see car loans as bad debt.
On the other hand, a car can expand your income potential by helping you get to and from work in areas where there is no reliable public transportation. Plus, a vehicle extends the distance you can travel for work, potentially allowing you to reach large cities where salaries are higher.
Personal loans are also traditionally viewed poorly, but they can play a role as good debt. They can be good when you use them to consolidate high-interest credit card debt. But this is only valid if the personal loan’s annual percentage rate (APR) is lower than the credit card APR.
For example, imagine you have $10,000 in credit card debt with 20% APR and a 4% minimum payment. If you pay the $400-per-month minimum payment, you’d pay $6,989.36 in interest charges over the 171 months it’d take to pay off the debt, according to Bankrate’s minimum payment calculator.
However, with a $10,000 debt consolidation loan at 10% APR for 60 months, you’d pay just $212 per month and a total of $2,748 in interest, according to Bankrate’s personal loan calculator.
The personal loan would speed up the rate at which you’d pay off your debt and reduce the amount of interest you’d pay. This builds net worth via debt elimination, thereby qualifying as good debt.
Keep in mind, not all personal loans are good debt, though. When used for the wrong reasons, like buying a consumer item, personal loans can negatively impact your finances.
Home equity lines of credit or home equity loans
A home equity line of credit (HELOC) or a home equity loan can be good debt when used the right way.
A HELOC is a line of credit you can use as you see fit. The HELOC is tied to the equity in your home — the amount the home is worth relative to the mortgage balance on it — and you can use as much or as little of the credit line as you’d like during the HELOC draw period. The lender only charges you interest on the amount of cash you draw from the line of credit.
A home equity loan also ties to the equity in your home, but this is a lump-sum loan instead of a line of credit you can draw from.
HELOCs and home equity loans generally have low interest rates — as low as 1.75% for HELOCs and 3.25% for home equity loans — so they are worth considering for debt consolidation. With these financial tools, you can pay off high-interest credit card debt quickly and, potentially, save big on interest charges.
HELOCs and home equity loans can also help increase your net worth if you use them to make needed updates, expansions or repairs on your home.
The downside is that since they attach to your home’s equity, they are also tapping into your net worth. As a result, there may be a short-term drop in immediate net worth with the potential payoff being more substantial net worth in the future.
Why is good debt important?
Good debt plays a wide range of critical roles. In your later years, things like mortgages and small business loans help you build net worth.
In your earlier years, careful credit card use, auto loans, student loans and other debts can help you build your credit score and qualify for considerably better good debt, namely a mortgage.
Do I need good debt to qualify for a mortgage?
Yes and no.
Yes, because few mortgage lenders will consider approving an applicant with no credit score, as they often view financial mystery the same way they view poor debt management. With an established payment history and a good credit score, the home lenders are more likely to approve you.
However, with a large enough down payment or a joint applicant with a good credit score, you may be able to get around your lack of credit score.
Can I build my credit score without credit cards?
Credit cards are simple tools for building credit, but some people aren’t comfortable with them. Fortunately, you don’t have to apply for plastic just to boost your score; there are alternative routes.
Credit-builder loans are for borrowers who want a loan for no other reason than to build their credit. The bank loans the borrower money, but it places the money in an account the borrower can’t access. The borrower then makes payments on the loan according to the terms, and the lender reports the on-time payments to the three credit bureaus.
Once the borrower pays off the loan, the lender releases the funds to the borrower. Sure, the borrower is out any interest payments they made, but it’s usually a small price to pay for a higher credit score.
Auto loans can also help build your credit. With the right car, down payment and lender, you may be able to get approved with no credit score — but, you may still need a cosigner.
A car loan is a credit card alternative to building a good credit score because it helps you balance your credit mix — the mixture of revolving and installment debt on your credit report — and boosts your payment history, which combine to make up 45% of your FICO score.
Don’t forget about student loans’ positive impact on your credit score. Once you leave school and start repaying your loans, they have the same positive impact on your credit score as any other loan.
Increase your good debt to build future wealth
While traditional good debts like mortgages, student loans and business loans remain strong long-term options for building wealth through debt, they aren’t the only game in town. For those just getting started in the personal finance space, some traditionally bad debts can be good debts when used the right way.
These bad debts gone good include credit cards, personal loans and auto loans. With these debts, you can build the credit score you need to get a mortgage in the future and further your wealth-building.
If bad credit card debt is damaging your finances, the Tally† credit card debt repayment app can help. Our app helps you manage your credit card payments, and Tally offers a lower-interest personal line of credit, allowing you to efficiently pay off higher-interest credit cards.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 to $300.