Good Debt vs. Bad Debt

Auto loans: A necessary evil

Vehicle loans occupy a gray area between good and bad debt. While transportation is often necessary for work and daily life, cars are depreciating assets that lose value rapidly. A new car typically loses 20% of its value immediately upon leaving the dealership and continues depreciating throughout its useful life.

The necessity of transportation for most people means that some form of vehicle financing may be unavoidable. However, the key is minimizing the financial impact by:

• Purchasing reliable, fuel-efficient vehicles rather than expensive luxury cars
• Securing low interest rates
• Paying off the loan as quickly as possible

Leasing vehicles can be even more costly than purchasing, as you’re essentially paying for the most expensive years of depreciation without building any equity. Unless you have specific business reasons for leasing, purchasing a reliable used vehicle often provides better long-term value.

Personal loans and payday Loans: High-cost financing

Personal loans for vacations, weddings, or other consumption purposes represent clear examples of bad debt. While the interest rates may be lower than credit cards, you’re still paying to finance consumption rather than investment.

Payday loans and similar short-term, high-cost borrowing options are among the worst forms of debt available. With effective annual interest rates that can exceed 400%, these loans can quickly trap borrowers in cycles of debt that are extremely difficult to escape.

The gray area: Debt that could go either way

Some forms of debt don’t fit neatly into good or bad categories and depend heavily on individual circumstances and how the debt is managed.

• Home equity loans and lines of credit: Borrowing against home equity can be either good or bad debt depending on how the funds are used. Using home equity to fund home improvements that increase the property’s value or to consolidate high-interest debt can be beneficial. However, using home equity to fund vacations or consumer purchases puts your home at risk for temporary consumption.
• Debt consolidation: Consolidating multiple high-interest debts into a single lower-interest loan can be beneficial if it reduces your total borrowing costs and helps you pay off debt faster. However, debt consolidation only addresses the symptom rather than the underlying spending habits that created the debt problem.

Leveraging good debt for wealth building

Sophisticated investors often use debt strategically to accelerate wealth building. This might involve:

• Maintaining low-interest mortgage debt while investing additional funds in higher-returning assets
• Using business debt to fund expansion that generates returns exceeding the borrowing costs

However, leveraging strategies require careful analysis and risk management. The potential for higher returns comes with increased risk, and borrowers must be prepared for scenarios where investments don’t perform as expected while debt payments remain fixed obligations.

The importance of interest rates and terms

Not all debt within the same category is equivalent. For example:

• A mortgage at 3% interest is fundamentally different from a mortgage at 7% interest, even though both represent borrowing against real estate.
• Similarly, a student loan with favorable terms and forgiveness options may be preferable to a private loan with variable rates and fewer protections.

When evaluating any debt, consider not just whether it falls into the good or bad debt category, but also whether you’re getting favorable terms relative to available alternatives.

The role of credit scores

Your ability to access good debt at favorable terms depends heavily on your credit score and credit history. To ensure you’ll qualify for the best rates when you need to borrow for legitimate investments (like homes or education):

• Maintain good credit by making payments on time
• Keep credit utilization low
• Manage credit accounts responsibly

Ironically, having access to credit often means you’re less likely to need it for emergency situations, while those with poor credit pay higher rates precisely when they can least afford the extra cost.

Avoid making good debt into bad

Many people make predictable mistakes when managing debt that can significantly impact their financial well-being. Understanding these pitfalls can help you avoid them in your own financial journey:

• Taking on too much debt, even good debt, can strain your finances and limit your flexibility. Lenders often approve borrowers for more than they can comfortably afford, making it crucial to do your own affordability analysis rather than relying solely on lending guidelines.
• Failing to shop around for the best rates and terms can cost thousands of dollars over the life of a loan. Even small differences in interest rates compound significantly over time, making it worthwhile to invest effort in securing the best possible terms.
• Using debt as a substitute for inadequate income or poor budgeting habits rather than as a strategic tool for wealth building often leads to a cycle of increasing debt and financial stress.

Watch out for

• Lenders who approve more than you can comfortably afford
• Loans with variable interest rates and unclear terms
• Using debt to cover everyday expenses instead of budgeting

The bottom line

Debt isn’t inherently good or bad, it’s how you use it that matters. By understanding the purpose, cost, and long-term impact of borrowing, you can make smarter decisions that support your financial goals. The distinction between good and bad debt provides a framework for making informed borrowing decisions, but it’s not a rigid rule system. Context matters, and what constitutes good or bad debt can vary based on individual circumstances, interest rates, tax situations, and personal goals.

The most important principle is intentionality. Every borrowing decision should be made with clear understanding of the costs, benefits, and risks involved. Good debt should have a clear plan for generating returns that exceed the borrowing costs, while bad debt should be minimized and eliminated as quickly as possible.

By developing a strategic approach to debt management, you can harness the wealth-building power of leverage while avoiding the financial traps that ensnare many borrowers. The goal isn’t to avoid debt entirely, but to ensure that every dollar you borrow works harder for your financial future than it costs you in interest and fees.

There’s always JG Wentworth…

Do you have $10,000 or more in unsecured debt? If so, there’s a good chance you’ll qualify for the JG Wentworth Debt Relief Program.* Some of our program perks include: 

• One monthly program payment 
• We negotiate on your behalf 
• Average debt resolution in as little as 48-60 months 
• We only get paid when we settle your debt  

If you think you qualify for our program, give us a call today so we can go over the best options for your specific financial needs. Why go it alone when you can have a dedicated team on your side?