Good debt. Bad debt. Is there really a difference? After all, in both cases you owe a lender and pay interest to use their money.

In truth, some forms of credit are better choices than others. Let’s find out which is which and why.

We’ll start by taking a look at types of debt, and when some may be considered good or bad. We’ll also offer a few easy tips that can help you quickly decide whether a particular type of debt is a wise choice for you, or not.

Types of Debt

Debt can appear in many forms and vary in many ways. Each can have a particular repayment schedule and terms and impact your financial health in various ways. However, most debt falls under four major categories; secured, unsecured, revolving, or installment.

Comparing Secured & Unsecured Debt

Secured debt is backed by an asset which is referred to as collateral. An example of a secured debt is an auto loan. The lender places a lien on the title which protects their investment.

If you do not pay your car payments, the lender can seize your vehicle to recoup at least some of their money. Secured loans generally have lower interest rates because of this safeguard.

Unsecured debt is not connected to an asset. Instead, the lender relies on your ability to repay your loan. As a result, they look at various factors to ensure you have the means to pay. This may include your income, credit, and other lender specific requirements. Since unsecured debt does not provide the assurance of collateral, interest rates are generally higher.

Comparing Revolving & Installment Debt

Another factor that differentiates debt forms is whether it follows a revolving or installment payment schedule. An example of revolving debt is a credit card. You can add to the balance at any time, providing you stay within your credit limit and make your payments on time. If you do not pay the entire balance, it transfers over to the next month and you’re charged compound interest on what remains.

Installment debt operates differently. The lender provides you with a lump sum and you pay regular payments. You can’t add to the balance, but when you make all your payments on time you also know precisely when you’ll pay off your debt.

Other Debt Considerations

Each form of debt has either a fixed or variable interest rate. Loans with fixed rates are constant throughout the loan term. Variable rate debt interest rates may or may not be a good thing depending on how the market fluctuates. If interest rates drop, so do your payments.

Debt can also cover very short or long periods. Short-term loans typically cover a year or less, while long-term ones are a year or more. The longer the loan term, the more you pay in interest. However, loans with longer terms generally have lower payments.

Good Debt vs. Bad Debt

So, is there actually a thing as good or bad debt?

Sometimes. It depends on how you use particular forms of debt and whether you handle them well.

Still, some debt is more expensive and burdensome than others and they should usually be avoided. On the flip side, some debt may provide benefits such as building your credit, while others do not. Consequently, if you need to borrow, you want to check whether the benefits make it worthwhile.

What is “Good Debt”?

According to Experian, good debt helps you achieve “meaningful growth in your personal life or finances. However, most financial professionals suggest that any debt can be “good” if it serves you well.

As an example, a credit card may not offer the lowest interest rate, but your timely payments can boost your credit scores.

Furthermore, having a credit card can be very convenient in some circumstances. Having one is only bad if you can’t pay off the balance straightaway. Then you pay unnecessary interest.

Examples of Good Debt

It is important to point out that none of this is written in stone. Every person’s financial and life situation differs, as do their decisions about taking on debt. Nonetheless, here are a few examples of what many consider good debt.

Mortgage to Buy Home

Most people would find it impossible to save up the money to buy a home in cash. That means they need to borrow to buy a home.

When you take out a mortgage you buy an asset and you hope your investment will increase in value over time. If this happens, you’ve built equity and can potentially profit from a sale.

You can also use this equity as collateral to borrow at a low rate if you want to renovate, buy another home, or invest. Consequently, a mortgage may help you build personal or financial wealth.

Student Loan

A student loan is considered good debt if it leads to better employment opportunities with the potential for a healthy income. However, you must choose your path wisely if you want to borrow to learn.

Auto Loan

Generally, an auto loan is not good debt because vehicles lose their value quickly. However, an auto loan can be a good debt if owning a vehicle makes it possible for you to work or look for a new job with a better earning potential.

What is “Bad Debt”?

Generally, think of bad debt as debt that takes money out of your pocket, but offers little or nothing in return.

Of course, bad debt is also debt that you cannot repay. If it negatively impacts your credit scores or you’re using most of the credit available to you (credit utilization ratio), that can be bad too.

Another reason a debt may be considered “bad” is because of its’ interest rate and the method of calculating interest owed. For instance, the average interest rate on credit cards is 20.35% and interest compounds on any remaining balance. This can may it much harder to pay back what you owe.

Another example of “bad” debt is payday loans. The Consumer Financial Protection Bureau suggests their annual percentage rate (APR) is almost 400 percent, compared to between 12 and 30 percent on credit cards. The APR on installment loans is often much lower than this.

Tips Regarding Good & Bad Debt

Obviously, no one wants to spend hours figuring out whether a debt choice is good or bad. Here are a few tips to help you decide.

Preserve Your Equity

If you’re faced with a decision between two debt options, go for the one that preserves your equity.

As an example, you may need money until your house sale completes. Don’t sell off investments to take care of this need. Take out a bridge loan and pay it off in full once you get the proceeds of the sale. This preserves your equity and you may avoid fees for cashing out investments.

Consider Leasing

If you like to have a new car every few years, you may want to lease instead of buying. This is especially true if you run a business since you can write off much of the expense. You drive a late model car and the leasing company takes care of the maintenance.

Measure the Lasting Benefit

Always consider whether the debt will provide you with something of lasting benefit. If it is just something that satisfies an immediate desire, it’s probably not good debt.

Use Your Emergency Fund

If you don’t an emergency fund, you should set one up now. It can cover unexpected expenses, instead of relying on expensive debt options such as credit cards.

Can a Lot of Good Debt Be a Bad Thing?

Yes, it can. While lenders may by happy to grant you credit, it is up to you to keep your spending under control. Always focus on paying off what you owe before you borrow again.

Pay on time and monitor the ratio of how much credit you’ve used compared to what you earn to keep tabs on your spending. This is called a debt-to-income ratio.

What is a Good Debt Ratio?

If you’re wondering how your debt-to-income (DTI) ratio measures up, almost all lenders want to see 36% or lower. This gives them the assurance that you have the means to easily repay a debt. The lower the DTI ratio, the more favorable you appear to lenders.

As mentioned, carrying debt may improve your life and financial situation, or it can become a burden. Fortunately, you have better options if your debt is primarily in high-interest credit cards or payday loans.

Can Good Debt Help You Manage Your Money Better?

Many people struggle to deal with multiple loans instead of making things easier on themselves. For instance, paying an auto loan, payday loan, and several credit cards could easily be consolidated into a single payment.

However, taking out additional loans isn’t always the answer. First, you must learn to manage your money properly. Otherwise, you’ll face the same problem repeatedly.

Of course, if you need to borrow and you can handle the debt well, you have many options beyond banks and credit unions. Alternative lenders offer easy online access and sometimes less stringent requirements too.

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