Most people assume debt is something to avoid no matter what. However, there are circumstances when “good debt” can actually provide you benefits. 

This type of debt benefits your financial future, while “bad debt” harms your economic potential. 

Investments that generate long-term value or appreciate over time are seen as beneficial debts that can help advance one’s future financial goals.

For instance, student loans allow individuals to invest in education and increase their long-term earnings potential. Mortgages are also considered a form of good debt, allowing people to build equity in a property rather than paying rent to a landlord. 

Additionally, small business loans can help start or grow a company and increase future profits and income.

“Good debt is distinguished from poor debt by its ability to generate a larger long-term financial return than interest costs,” Andrew Gosselin, certified public accountant and a senior editor at the Calculator Site, told the Washington Examiner.

Bad debt typically consists of high-interest consumer debts, like credit card balances used for nonessential purchases, that offer little to no long-term value. 

With APRs ranging from 12% to 30%, this type of debt can accumulate quickly and become a financial burden if not managed effectively. 

When considering the cost of a loan or line of credit, it is important to distinguish between the interest rate and the annual percentage rate. The interest rate is what you pay to borrow money and is partially based on your credit score.

On the other hand, the APR combines the interest rate and any additional fees on the loan, which is primarily controlled by the lender.

In this way, lower interest rates may lead to lower monthly payments, even though the total cost of the loan could still be higher.

However, a lower APR may result in a reduced total cost of the loan, although your monthly payments might be higher.

Over the last 10 years, the average APR on credit cards nearly doubled, increasing from 12.9% in 2013 to 22.8% in 2023, which was the highest level recorded since the Federal Reserve began collecting data in 1994.

The Federal Reserve controls the federal funds rate, which is the interest rate for interbank lending. Based on this, each bank then determines their prime rate, which in turn affects your credit card APR.

Therefore, if the federal funds rate and prime rate increase, your card’s APR will likely also rise.

For instance, the Federal Reserve raised interest rates between 2022 and 2023 to curb demand and address inflation. As a result, credit card APRs also increased during this period. 

“Taking on debt to buy important assets like a house, a place of education, or an income-producing investment property can be a wise decision,” Gosselin said. “However, it is rarely profitable and drains resources to use high-interest credit card debt for hasty expenditures.”

Another example of bad debt is payday loans, which are typically small loans under $500 that must be repaid by the next payday. These loans carry substantial fees, usually between $10 and $30 for every $100 borrowed.

Some states have banned these loans, including Arizona, Arkansas, Washington, D.C., Georgia, New Mexico, and North Carolina. 

Opponents argue that these loans are “predatory” because they target low-income borrowers with high interest rates.

The Consumer Financial Protection Bureau intends to begin implementing regulations on payday loans after a Supreme Court ruling last month resolved a challenge to the federal agency’s authority to act.

Overall, even the most common forms of good debt come with risks. When considering a loan, it’s important to assess how taking on debt will affect one’s life and to have a solid plan for repayment.

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“The key is getting reasonable interest rates and making sure you can afford the payments,” said Steven Kibbel, a certified financial planner and financial adviser at Prop Firm App. 

“My best advice is to approach all debt with eyes wide open. Only take on what you can manage and know the implications. Good debt should move you forward — not hold you back through crushing interest payments.”