Quick Answer
Good debt finances assets or activities whose return exceeds the borrowing cost; bad debt finances depreciating consumption at rates that compound against the borrower.
Key Takeaways
- Purpose matters more than the label on the loan - a mortgage on an unaffordable home is still bad debt.
- Interest rate and tax treatment are the two largest variables in the good/bad calculation.
- Bad debt does not have to stay bad - refinancing and consolidation can shift the profile.
The Four Tests
Educational frameworks typically evaluate debt against four tests: does it finance an asset that appreciates or produces income, is the interest rate lower than expected returns, is interest deductible, and can the household service it under stress.
Debt that passes most of these tests is generally categorized as 'good.' Debt that fails most is typically categorized as 'bad.'
Common Examples
Mortgages, federal student loans for credentialed fields, and modest business financing are frequent examples of debt categorized as productive.
High-interest credit card balances on consumption, payday loans, and auto loans larger than the vehicle's depreciated value are frequent examples of debt categorized as unproductive.
Common Mistakes
- •Assuming the label of the loan determines its quality.
- •Treating all credit card spending as bad debt even when paid in full monthly.
Related Concepts
Frequently Asked Questions
Is a mortgage always good debt?
No. A mortgage on a home the household can comfortably afford, in a stable market, is usually categorized as productive. A mortgage that stretches the borrower beyond their debt service capacity can behave like bad debt regardless of the asset.