Can borrowing build wealth? Good Debt vs. Bad Debt

Many of us grew up with the idea that debt is always bad and should be avoided. But is that really true?

When used responsibly, debt can be a helpful tool. It could help you access things that you couldn’t afford to pay for upfront, like a house or higher education.

In the right situations, it could even improve your long-term financial position by helping you increase your wealth or access a higher income.

In this guide we’ll discuss the difference between good debt and bad debt. And we’ll share some tips for managing your debt wisely and how to avoid falling into bad debt. 

 

What’s good debt?

Generally, good debt is the kind of borrowing that improves your financial position in the long run.

It’s debt that helps you invest in something that grows in value, increases your income, or boosts your net worth.  Examples include borrowing to:

• Buy a home.
• Pay for education.
• Start a business.

Good debt can be beneficial, if used wisely and with careful planning to make sure it’ll pay off in the future.

However, what truly separates good debt from bad debt is how it’s managed. Even good debts can become bad if you can’t afford to pay it back on time.

When could debt be good?

Here are some types of debt that can be considered ‘good debt’ when used responsibly:  

1) Mortgage

A mortgage is a loan used to buy a house. While the debt can be large, it’s generally considered a good debt.

Here’s why:

• Building wealth: As you pay off your mortgage, you’re investing in an asset (the house). This can help you build wealth over time.  
• Value increase: Houses usually increase in value over time. If the value of your house goes up as you pay off your mortgage, you can increase your net worth.
• Secured loan: A mortgage is a secured loan, meaning the lender could take back the house if you don’t make the payments. However, this also means that interest rates are typically lower compared to other types of loans, because the lender has security.

Of course, any debt comes with risks, so it’s important to make sure you can afford the payments to avoid losing your home.

2) Student Loans

A student loan is money borrowed to pay for education, such as:

• University degrees.
• Career-focused certifications.
• Upskilling courses.

This is usually considered good debt because investing in your education could lead to better career opportunities, higher earnings, and greater financial success.

Student Loans in England:

In England, most students get loans from the Student Loans Company, which could also be considered good debt because:

• Repayments only start when you earn over a certain amount (see more info on this here).
• You pay a percentage of your earnings above that amount, so the more you earn, the more you pay back.
• If you don’t earn enough, you don’t need to repay the loan right away.

3) Small business loans

A small business loan is when you borrow money to start or grow a business. This type of debt could be considered good debt when used wisely.

Here’s why:

• Income generation: If your business is successful, the loan can help you generate more income over time. This could boost your financial situation and help you gain wealth in the long run.

But remember, you should always calculate the risks of borrowing money to start a business before taking out a loan.

4) Personal loans

An unsecured personal loan is a type of loan that doesn’t need you to promise an asset, like your house, if you can’t repay it. Unsecured personal loans can be good debt when used smartly, such as:

• Debt consolidation: You could use a personal loan to combine multiple debts into one loan with a lower interest rate. This could boost your long-term financial position.

Just make sure to only borrow what you need to pay off your debts.

5) Car loans (sometimes)

A car loan is money borrowed to buy a new or used car. Whether a car loan is good or bad depends on how it affects your long-term financial situation.

Here’s how:

• Bad debt: Taking out a high-interest loan to buy a flashy car that’s beyond your budget would usually count as bad debt. Cars typically lose value over time, so borrowing too much for one is unlikely to help your long-term finances.
• Good debt:  On the other hand, a car loan could be good debt, if it helps you get to work or run your business. This is because it’s a tool that could help you increase your income or wealth.

This shows the importance of careful planning when taking on new debt to avoid bad debts.

Good debts are carefully planned

Good debt is about making smart, calculated decisions that can improve your financial situation in the long run. Here’s what that means:

• Purpose: Good debts are usually tied to something that can boost your income or increase your wealth over time.
• Planning: Before taking out any new debt, careful planning is key. That means calculating the costs, understanding any fees or risks and making sure you can afford and have budgeted for the payments.
• Long-term: Good debt generally looks beyond immediate benefits to the long-term. That means making sure the debt will pay off by improving your financial position in the future.

Risks of good debts

Even good debt comes with risk. While good debts are meant to improve your financial situation in the future, things don’t always go as planned. For example:

• House value: you might expect your house to increase in value, but the market could change, leaving you with less value than you anticipated.
• Business success: your business might not end up as successful as you thought it would be.
• Careers: despite borrowing to pay for new certifications, it might not translate into a higher-paying job.

Before taking on debt, always work out if you can comfortably afford the repayments.

Debt-to-income ratio (DTI)

One factor to consider when planning to take on more debt is your debt-to-income ratio (DTI). This shows what percentage of your monthly income (before taxes) goes towards paying off debts.

Here’s how to work it out:

1. Add up all your monthly debt payments.
2. Divide that number by your monthly income before taxes.
3. Multiply the result by 100 to get your DTI percentage.

A lower percentage is better because it shows that you’re not spending too much of your income on debt payments.

But remember any debt can turn bad if not managed well.

 

What’s bad debt?

Bad debt is borrowing that negatively impacts your financial situation, especially in the longer-term. Here’s what is usually seen as bad debt:

• Any debt you can’t afford to repay on time.
• Expensive (high-interest/variable) debts, especially when used to fund a lifestyle beyond your means or for things that go down in value over time.

If you are struggling with debt, help is available. You could reach out to these organisations who offer free, impartial debt help:

• StepChange on 0800 138 1111
• MoneyHelper

When could debt be bad?

Not all debt is helpful for your financial future. Here’s some borrowing that could be considered ‘bad debt’:

1) Debt you can’t afford

Debt becomes bad when you can’t keep up with the payments. Missing payments can have serious long-term effects on your finances.

One impact could be making your credit score drop, which might make it harder for you to borrow or get good interest rates in the future.

A low credit score could also affect your ability to:

• Get a phone contract.
• Rent a property.
• Qualify for certain jobs.

(See: How important is your credit score? )  

Plus, having debt you can’t afford could bring you a lot of stress. That’s why it’s important to only take on debt that fits comfortably within your budget.  

2) By Now Pay Later

By Now Pay Later (BNPL) is a type of debt that lets you split payments for items over time, which can be handy if used responsibly.

But BNPL debt can become bad debt if you:

• Use it to pay for a lifestyle that you can’t afford or things that you don’t need.
• Borrow to pay for things that will decrease in value quickly, like clothes, gifts or takeaways.

• Forget to make payments on time, which could lead to higher interest rates and late payment fees, making your debt even more costly. 

3) Expensive credit cards

Credit cards also let you spread out the cost of purchases, and if you pay off your balance (debt) in full each month, you usually won’t pay any interest.

But if you can’t clear your balance every month, credit card debt can quickly become bad debt. Here’s why:

• High interest rates: Carrying your balance from month to month can lead to high interest rates on credit cards. This can make your debt grow quickly and put you in a worse financial position.
• Credit score impact: Maxing out your credit cards (getting close to or exceeding your credit limit) can lower your credit score.
• Funding spending habits: Using your credit card for things that lose value is unlikely to help your financial situation in the future – you’ll end up with debt but no lasting value.

To avoid bad credit card debt, try to pay off your balance in full each month, spend below your credit limit, and only use your card for essential purchases or things that will keep their value.

Questions to ask yourself to avoid bad debts

Before borrowing, it’s important to ask yourself a few key questions. These can help you make smart decisions and avoid bad debts:

1. Can I really afford the repayments? 

2. Will this debt improve my financial situation in the long run?

3. Is there another way I could pay for this?

These questions can help you assess whether a new debt will help your finances in the long run – or if they should be avoided.

Building credit history

You might wonder ‘is it better to avoid debt completely?’.

While that might seem like a good idea, avoiding all debt could also actually cause some problems if you need to borrow later in life.

If you never borrow or use credit, you won’t have any credit history – that could mean you don’t have a credit score either.

Being ‘credit invisible’ or having a ‘thin credit file’ can make it hard to:

• Borrow money in the future (such as for a mortgage, loan or credit card).
• Get the best interest rates on any borrowing.

Why?

You might think having no debt will give you a good credit score, but that’s a myth. Lenders want to see how well you handle credit.

They use your credit history, along with other factors, to figure out how likely you are to pay them back.

Instead of avoiding debt completely, you might want to consider using some borrowing to build your credit history. But remember:

• Always make your payments on time.
• Keep your spending well under your credit limit.

By managing debt well, you can boost your credit score over time and build a good credit history. Just make sure to only ever take on debt you’re able to afford and can manage responsibly.

Key takeaways

• Debt, like most things, can be good or bad – it depends on what you’re using it for and how you manage it.
• Borrowing that helps you increase your income, build wealth or improve your financial situation in the future is typically seen as good debt.
• In general, bad debt is any borrowing that you can’t afford or that doesn’t help your financial situation in the long run.
• All debt has the potential to become bad debt if it’s not managed responsibly.
• It’s important to carefully understand the impact of any new debt on your current and longer-term financial situation.