For most, debt is a normal part of life. Debt is taken on by consumers for a variety of reasons, not all of them good. Because debt can very quickly take your finances in the wrong direction, it’s essential to understand the difference between good debt and bad debt.

Let’s dive into what differentiates the two below.

Good Debt

Generally speaking, if a debt either helps you increase your net worth or helps you increase your income, then it is considered good debt. Some examples of good debt can be:

• Real Estate Debt - This is a prime example of good debt. Whether you purchase a home to live in and sell it for more down the road, or if you purchase commercial real estate and rent it out or sell it to businesses - this type of debt is quite often a good investment opportunity if handled correctly.
• Business Debt - Taking out a loan to support your current business or a new business venture can be smart if handled appropriately. You’ll need to make sure you have a good business plan in place and also that you have the ability to repay the loan within a reasonable amount of time. Quite often, loans are just what a business needs to gain the capital to grow and prosper.
• Educational Debt - Student debt is a perfect example of good debt because it helps you to increase your earning potential. When you’ve completed a degree in higher education you are more likely to be paid higher and to have an easier time being hired. While this is an example of god debt, it’s also important that you don’t carry this debt for longer than necessary. Be sure to work repayment of your student debt into your budget as soon as possible so you don’t carry it for too long. You should aim to have it repaid within a few years.

Bad Debt

A debt is considered bad if it is used to purchase assets that will depreciate in value over time and/or won’t generate any income. Some examples of bad debt are:

• Goods and Services - You can’t recoup the amount you spent in money and interest on things like clothing, electronics, vacations, etc. Generally speaking, it’s not a good idea to maintain debt on these things as they won’t improve your financial standing typically.
• Credit Cards - Credit card debt is the most common type of bad debt. Interest rates tend to be high and carrying a balance will ensure you pay more out of pocket on your purchases than what their original value was.
• Auto Loans - Cars depreciate in value the moment you drive them off the lot. The cost of vehicles is high, and depending on the type of loan that you’ve taken out to purchase it, you could wind up paying more in interest on the vehicle than you should. Also, by the time you go to trade in or sell the car, you’ll be getting back a substantially less amount for it than you initially paid. It’s usually a good idea to pay for a car in cash whenever possible.
• Debt Consolidation Loans - Debt consolidation may be a good option for you to more easily and quickly pay off your debts, however, it is considered a bad debt because you are taking on more debt in order to eliminate pre-existing debt. While this may put you in a better financial position if handled properly, it will not increase your net worth or bring in more cash flow. It’s also possible for debt consolidation to place you in a worse credit position than before if you don’t pay off your debt within a reasonable amount of time, default on the loan, or if you continue to accumulate debt after consolidating.