Debt: The Good, the Bad, and the Ugly

Sometimes debt might seem like a trap that you only want to fight your way out of, but not all debt is bad. If you’re focusing on getting out of debt, you first need to understand which debts are considered bad and which are considered good.

Good debt is defined as investment debt that creates value; for example, student loans, real-estate loans, home mortgages and business loans. Since homes usually appreciate in value, the mortgage loan you take out to pay for the home is an investment. Another example of a good debt is a student loan taken out to finance a college education. Earning a college degree usually means that you’ll make more money over your lifetime.

In some cases, it is recommended to take on debts that are tax-deductible, and debts that produce more wealth in the long run. If you are talking about reducing current debt, that's where it starts to get nuanced. If you take a home equity loan because you have 17 percent credit card, and you go with a 6 percent loan that's tax-deductible, that's good debt.

These general rules of thumb set some clear delineations -- buying a home or refinancing to get rid of excessively high rates is usually good debt, as is generating debt to buy high-return stocks, bonds and other investments.

The concept of bad debt comes in when discussing the purchase of disposable items or durable goods using high interest credit cards and not paying the balance in full. When you use debt to finance things that can be consumed, you aren’t accumulating good debt. This is the kind of debt that creates an unhealthy financial situation. Credit card debt is often considered bad debt because of the nature of items that credit cards are used to purchase. You should never accumulate debt to purchase everyday items like clothes or food. If you use a credit card for these types of purchases, you should pay the balance in full each month.

Every month that you make a partial payment on your credit account you are charged interest. The disposable or durable item you purchased continues to lose value, and the amount you paid for it continues to increase. When you buy clothes, they're probably worth less than 50 percent what you pay for them when you walk out the door. So if you borrowed to pay for them, that's bad debt.

Good debt is obtained through making wise decisions about your future, not for the sole purpose of having good debt. You must still be careful that you don’t take on too much debt, even if it’s good debt. If you’re overloaded with debt, then it doesn’t matter whether the debt is good or bad, it still hurts your financial health.