Thanks to the economic downturn and its lingering effects, the word “debt” predominantly carries a negative connotation. But you may have heard in the midst of balancing your budget or planning for retirement, that not all financing is created equal. In fact, some debts, experts suggest, may be good for you. But what exactly does this mean?
What Is Good Debt?
Simply put, good debt “is any debt that offers a return on the investment,” Rod Griffin, director of public education for credit bureau Experian, said. For instance, a mortgage is often considered good debt since “in normal times, [the home associated with it] has some gain in equity,” he said. Other examples of good debt can include student loans (with the return being the higher salary and improved job prospects you could command with an education) or even low-interest lines of credit you take on in order invest in stocks or retirement funds.
What Is Bad Debt?
Bad debt, on the other hand, is debt that’s going to land you in financial trouble, Griffin said. It’s any credit that you’re taking out or utilizing without a clear-cut plan of how to pay it back. Using a high-interest credit card to cover a shopping spree or taking out a payday loan to make extra holiday purchases are examples of bad debt.
Does My Credit Score Reward Good Debt?
Technically, no. Most credit scoring models do reward you for having a diverse portfolio of accounts and revolving debts (like credit cards) are often weighted more heavily than installment loans (like auto financing) because you determine how much credit you are going to use and pay off each month, Griffin said. But determining whether debt is good or bad is more of a financial management concept — not a credit scoring standard.
“Scores don’t distinguish between what we define as good debt and bad debt,” Griffin said. Instead, they look at how well you’re managing all your credit lines. Making on-time payments and keeping balances low is important whether or not there’s a long-term investment to recoup on the financing. You can see how your current debts are affecting your credit scores by viewing your free credit report summary each month on Credit.com.
How Can I Avoid Taking on Bad Debt?
First off, remember that you don’t have to take every credit offer that comes your way, Griffin said. Instead, ask yourself before formally applying if you will be able to pay off the debt, when you will be able to pay off the debt and what you will be giving up to take on the new liability.
“Look at your overall financial picture,” Griffin said. “If you don’t have a plan to pay something off, it’s probably a bad debt.”