- It's possible to use debt to improve your financial situation.
- Certain types of debt are better than others, so it's important to be mindful of how you borrow and when.
- Taking on too much debt—even the "good" kinds—can put too much stress on your budget.
Debt often gets a bad rap, and for good reason. Certain types of consumer debt, such as credit cards and personal loans, can be incredibly costly, and short-term loans like payday and pawnshop loans are downright predatory.
"If you continue to miss these payments due to the high interest rate, then you may end up entering insolvency," says Scott Nelson, founder of personal finance website MoneyNerd.
But debt isn't always detrimental to a financial plan. In some cases, it's possible to use debt as leverage to improve your financial situation by borrowing at low interest rates and using your cash to invest instead. As you navigate your money management decisions, it's important to be mindful of what types of debt you use and how much. Here's what to consider.
Good debt vs. bad debt
Some financial experts consider all forms of debt to be bad, primarily because it's very easy for some people to get sucked into a vicious cycle. Taking on too much debt, especially if it carries a high interest rate, can be financially crippling.
But instead of simply avoiding borrowing altogether, it's a good idea to take a more nuanced approach to using debt. One way to do that is to split the different types of credit into "good" and "bad" categories.
This isn't to say that all good debt is worth having or that you can't take on too much of it. But in the right scenarios, you can use good debt to improve your life and financial well-being. Here are some different ways you might look at some of the types of debt that are available.
Mortgage loans are often considered to be a good debt, and for the majority of homeowners, unavoidable. In April 2022, 74% of all home sales were completed using a mortgage loan, according to the National Association of Realtors.
In some areas, it may be cheaper to rent than to buy a home and make a mortgage payment. But over time, the equity you build in the home can add significant value to your net worth and create more financial opportunities in the long run.
Additionally, owning a home can give you more control over your living space because you don't have to ask for permission to make changes.
Small business loans
If you're looking to build a business, it's often required to take on debt, especially when you're just starting out or you want to expand your business. Within the small business loan umbrella, though, there can be good and bad debt.
For example, a bank loan, line of credit, SBA loan or microloan can be affordable, and they can also help you grow your business and income. But merchant cash advances, invoice factoring and short-term online loans can be expensive and do more harm than good to your business.
In an ideal world, you wouldn't need to borrow money to attend college, and, fortunately, there are plenty of forms of financial aid that can help you pay for school without resorting to student loans.
But for most people, borrowing money to obtain a degree can help them earn more money over their lifetimes. Here's the median earnings for each type of degree, according to a report by the Georgetown University Center on Education and the Workforce:
|Education level||Median lifetime earnings|
|Less than a high school diploma||$1.2 million|
|High school diploma/GED||$1.6 million|
|Some college||$1.9 million|
|Associate's degree||$2 million|
|Bachelor's degree||$2.8 million|
|Master's degree||$3.2 million|
|Doctoral degree||$4 million|
|Professional degree||$4.7 million|
Taking on too much student loan debt can be detrimental to your finances, though, especially because there's no guarantee that you'll get the salary you're hoping for. So, it's important to seek out other forms of financial aid first.
Taking out a loan to buy a depreciating asset—a car starts losing value the minute you drive it off the lot and keeps losing value over time—can be a good or bad thing. If you can score a low interest rate on a car loan, you can use the money you would've spent on the car to invest and get a better return.
But if your credit is in poor condition and your interest rate is high, you're much better off buying a car with cash. You could avoid a “bad” auto loan by budgeting and saving up for your wheels instead of borrowing.
The average interest rate on a credit card is 16.17%, according to the Federal Reserve and many cards charge upwards of 20%. Given these high rates, you can end up repaying far more than you borrowed on a credit card if you have a remaining balance each month.
For example, if you have $5,000 in credit card debt and it takes you three years to pay it off, you'll end up paying about $1,343 in interest—that's almost 27% of the original balance. That makes credit cards a form of potentially bad debt.
That said, if you can manage to be disciplined with credit cards and pay your bill in full every month, it's possible to build credit without paying a dime in interest.
"A credit card is the best way for you to improve your credit score by making regular payments to show your payback ability," says Nelson.
In some cases, it can be worth it to get a personal loan if you can secure a low interest rate. This is especially true if you're looking to consolidate and pay off your high-interest credit card debt.
Low-interest personal loans could also be used for home renovations, especially if you don't want to take out a secured home equity loan or line of credit. However, it's generally best to avoid using personal loans to pay for a vacation or other unnecessary expenses, and you should be mindful of the interest rates, which can easily get into double digits.
Many payday lenders and pawn shops often offer short-term loans that you typically have to repay within just a couple of weeks. These loans don't require a credit check, so it's possible to get one even if your credit is in poor shape. Payday loans are unsecured, but pawn shop loans may use your auto title or another asset as collateral.
The average APR on these loans are often in the triple digits, with payday loans going as high as 400% or more in some cases. As a result, it's best to avoid these loans in general.
Keep an eye on your debt-to-income ratio
Regardless of which types of debt you use, it's important to be mindful of how much you borrow. Your debt-to-income ratio (DTI) is an important indicator of financial health and represents the percentage of your gross monthly income that goes toward debt payments.
Lenders generally consider a DTI of 50% or more to be too high, but the lower it is, the better, especially if you want to apply for a mortgage loan. The important thing is that you only take on debt if you can afford to make the monthly payments. If your mortgage is too large, for instance, you may be considered "house poor," which means you don't have enough income left over every month for other debts and important financial goals.
You can calculate your DTI by dividing your total monthly debt payments by your gross monthly income. There are two ways to reduce your DTI: increasing your income and decreasing your debt payments by paying off loans and credit cards.
Debt can help—or harm—your finances, credit score
Before you borrow money, it's important to think about your reasons for borrowing and how the debt can help improve your lifestyle and financial situation. It's also a good idea to consider whether you can achieve your goal without using credit.
While credit cards can be tempting with their sign-up bonuses, rewards and other perks, for example, your interest charges may outweigh the value you get unless you pay in full every month.
"The one thing you need to be careful of when taking on any kind of debt, good or bad, is the factors that make up your credit score," says Nelson.
As you use debt to build your credit history and meet other financial needs, it's crucial to be mindful of how much of your income is going toward debt payments every month. If you put too much strain on your budget, it may be difficult to keep up with your payments, which can cause long-term problems. To avoid that, now may be the time to create or optimize your budget.