- Bad debt can burden you with exorbitant interest rates and fees as well as short repayment terms.
- Good debt, such as a student loan, can become “bad” over time if it negatively impacts your finances.
- Credit cards and payday loans are two of the most common examples of bad debt.
- You can avoid bad debt by calculating your debt-to-income ratio, budgeting and establishing an emergency fund, among other strategies.
Debt has such a negative connotation that you might think it’s all bad. Truly bad debt, however, is in its own category.
“I like to say, ‘If you owe money, and you are not sure what you purchased using the money, that is bad debt,’” says Becky House, a former credit counselor and current director of strategic initiatives at American Financial Solutions (AFS), a national nonprofit agency.
Whereas good debt might help you buy a home or pay for college tuition, bad debt can burden you with high interest rates and monthly payments—and, yes, for expenses that weren’t altogether necessary.
To really understand bad debt’s potential effect on your personal finances, let’s look at how bad debt manifests itself, including some common examples.
What is bad debt?
The definition of debt is borrowing something (cash, in our context) with the understanding that you will pay it back.
Bad debt, then, is borrowing when…
It’s for an unnecessary expense (read: jet ski)
You don’t have a realistic plan for on-schedule repayment (either because you’re borrowing unwittingly or beyond your means)
Your repayment becomes unaffordable over time (perhaps due to factors outside your control)
It causes your credit history to suffer (making it harder to qualify for “good debt”)
Good debt, on the other hand, is borrowing to invest in yourself or your future. Most homeowners take on a mortgage (or home loan), for example, to gain equity in a valuable asset and increase their net worth over time. And many students take out education debt for college so that they can qualify for higher-paying jobs after graduation. (These types of debt are also “good” because your interest payments toward them are tax-deductible.)
Still, “any debt has the possibility of becoming bad debt,” says the AFS’ House. “The reality is that people make the best decision they can with the information and resources available to them.”
Student loans, for instance, can become bad debt if you drop out of school before graduating or don’t use your expensive degree in your eventual career field.
A loan or line of credit can also be termed bad debt based on its repayment terms. Characteristics of bad debt include:
High fixed interest rates (or variable rates that can jump even higher)
Short repayment terms
Unaffordable monthly payments
Not reported to credit bureaus (meaning it won’t help you improve your credit)
Understanding bad debt
At times, bad debt is bald-faced at the time you’re borrowing it. A borrower might knowingly take out a high-interest personal loan to pay for a vacation, for example, when the vacation could have easily been put off.
Sometimes, though, you may borrow money with good intentions only for your repayment to sour later. Perhaps you put not-so-necessary expenses on a credit card right before losing your job, for instance. You might then be thrust into a debt cycle where it’s no longer feasible to zero your balance each month.
Other times, bad debt is simply necessary. Maybe you use that high-interest credit card to cover crucial expenses like rent soon after seeing your wages drop or disappear. You know it’s bad debt when you see it, but it’s unavoidable.
The goal is to recognize bad debt for what it is, and to limit your borrowing of it as possible.
“Plan for the worst case scenario,” says House. “Like could (you) lose your job tomorrow and live within the means you’d have then? It isn’t easy, but it allows you to save and can help you keep borrowing at a minimum.”
Examples of bad debt—and how to escape them
One good way to avoid bad debt is to keep tabs on your debt-to-income (DTI) ratio. Your DTI is as simple as your total monthly debt payments divided by your gross (pre-tax) monthly income. It’s wise to have a healthy DTI for a mortgage, for example.
If your DTI is high, say above 50%, you might hold off on new borrowing. As mentioned though, sometimes you could be forced to take on bad debt as a last resort. Below are common examples of bad debt.
|Bad debt||Why it can be "bad"||How to make it better|
|Auto loan||Auto loans can have relatively lower interest rates (since they’re secured by the collateral of the car itself). Still, this can be bad debt because you’re borrowing for a depreciating asset. Most new cars lose 20% or more of their value as soon as they’re driven off the dealer’s lot.||Making on-time and extra payments toward an existing auto loan can help you end the debt and improve your credit score. To avoid this loan in the first place, though, you might budget and save up for your wheels, or set your sights lower, perhaps on an old beater.|
|Credit card||The plastic in your wallet may come with nice perks, such as cashback or other bonuses. It also comes with higher APRs than most financing products, though, so this is bad debt unless you can zero your balance at the end of every month to avoid the toll of interest entirely.||Get religious about paying off your entire balance each month. Also, consider avoiding the temptation of buying what you can’t afford by switching to a cash-only life (such as the cash envelope method). It’s a hassle to go to the ATM, but it’s a surefire way to avoid this bad debt.|
|Payday loan||If you thought that the repayment terms of the bad debt above were bad, this is worse: The average payday loan APRs approaches 400.00%, and often require repayment on weeks-long contracts. It’s a truly last resort option for consumers.||For a short-term solution, ask about borrowing options at your local, nonprofit credit union, or from family and friends. Budgeting and establishing rainy-day savings are good longer-term solutions.|
|Personal loan||Personal loans can be great for debt consolidation, but it could also be tempting to use them for unnecessary purchases. Unfortunately, that could mean borrowing at double-digit APRs on two-to-five-year repayment terms for major expenses like weddings, vacations and home improvements that could be budgeted or financed more efficiently.||Though personal loans can be used to improve your credit, it’s an expensive way to do it. You may have better options. For example, you might prioritize a lower-interest home equity loan instead of a personal loan when it comes to remodeling your house.|
It’s not possible for all consumers of all income levels to avoid bad debt. That said, you can improve your chances of only borrowing good debt by employing the following strategies:
Save up an emergency fund: It’s generally recommended to sock away three to six months worth of expenses (ideally in an account that’s both accessible and interest-bearing) so that you won’t have to resort to credit cards, payday loans and other debt with exorbitant interest rates.
Press pause on discretionary purchases: If you’re tempted to shop for a nice-to-have, whether it be a material item (like a new smartphone) or an experience (that epic vacation), postpone it. Ask yourself whether this purchase will be worth the financial wrangling it might take to finance it. If it is, see if you can avoid borrowing altogether by creating a budget and saving up for the expenditure a little bit at a time, over time.
Pay off your current debt: By strengthening—and lengthening—your payment history on your existing balances, you can improve your credit score. With that heightened score, you’ll then be in a position to qualify for lower interest rates and friendlier repayment terms when you need to borrow again in the future, whether it’s for a mortgage or a better credit card. At the end of the day, you can sometimes avoid bad debt simply by qualifying for better debt.
What is a bad debt-to-income ratio?
Generally, if you have a DTI above 43%, you might have a hard time paying off all your debt on schedule. That said, some lenders will approve loan or credit applications with higher DTIs if your application has other strengths, such as an excellent credit score or valuable assets.
How long does bad debt stay on your credit report?
Bad debt stays on your credit report the same length as good debt. However, many negative debt repayment events— such as late or missed payments or debt sent to collections—will stay on your report for seven years.