Good Debt vs. Bad Debt: Which Kind Do You Have?

Kathleen – not her real name – pulled a tissue from the box on the table and dabbed her eyes. “Kimberly, this is so embarrassing to admit but, I can’t figure out where my money is going. I have a good job, and I’m putting money in my retirement account, but I still feel like every month is a toss-up on whether or not I’ll be able to stay ahead of my bills.”

As a financial planner, I hear confessions like this from more clients than you might think. Even respected professionals who are good at their jobs sometimes find themselves in over their heads because of bad spending habits that have crept in gradually over months or years. All it takes is an expensive medical bill, a temporary business downturn, or a corporate downsizing and it starts to feel like the wheels are coming off.

When you think about it, all of us, at one time or another, find ourselves in situations where we can’t see the forest for the trees. Life happens, complications occur, and we get overwhelmed. Think about the last time you were “stuck” like that. When you’re starting to feel like everything is just too much; what you need is someone who can help you take a step back, get a grip on the big picture, and figure out a path forward.

For many Americans, the “forest” is debt – and the growth seems to be spreading. Since the pandemic, when many used the government’s relief payments to shed debt, U.S. households have reversed course, piling on debt at an alarming rate.

As shown below, U.S. household debt is currently growing at the fastest rate since the financial crisis of 2007–08. In 2023, credit card debt balances rose more than many other loan types. Credit card balances increased by $50 billion and are now at $1.13 trillion – a 4.6% increase – according to data released by the Federal reserve Bank of New York.¹ This might not have been as concerning when interest rates were low, but today’s higher rates mean that it has become increasingly expensive to pay the monthly charges that are accruing so rapidly. Credit cards have some of the highest interest rates sitting at 22.8% as of 2023.²

SOURCE: US Bureau of Economic Analysis

If you add in mortgage debt – and as we know, those rates have gone up in the past couple of years as well – American consumers are now looking at an estimated $600 billion in annual interest payments. Most of us know that consumer spending is a big part of the economy’s health and growth; some economists are worried that so much money sucked out of the pockets of American consumers will depress their ability to keep buying products and services at recent rates. And if the economy’s consumer spending “engine” runs out of steam, we could be at risk of a recession.

This might not seem like a real problem. After all, the economy still seems to be humming along, right? Inflation is down (but not out), unemployment is still low by historical standards, and GDP growth is healthy. Worker wages continue to rise. Should we worry?

Good debt or bad debt?

It’s important to take a step back and understand where you fit in the big picture. Because on the individual level, it’s not just about how much debt you carry, though that is certainly important. It’s also about the nature of your debt. Is it good debt or bad debt? And how can you tell the difference?

The simple answer is that good debt comes from borrowing to enhance your future net worth or personal prospects. You might put a home mortgage in this category, since over time your residence tends to appreciate. And if you were fortunate enough to acquire a mortgage loan a few years ago when rates were at 4% or less, the opportunity cost likely makes it more advantageous for you to hang onto that low-interest loan.

Borrowing to pay for higher education might also be considered good debt, but there’s a fine line. If the degree you or your child are financing with student loans doesn’t lead to a job that will generate enough income to pay the interest and principal, then the debt moves into the “bad” range.

Small business loans, if the money is used wisely, can be considered good debt. As we know, small businesses are the backbone of the American economy. If the company uses the loan proceeds to add staff to scale the business, to pay for a key marketing campaign to expand the company’s reach, or to otherwise increase the value of the company, it’s probably good debt. Of course, if the money is not deployed wisely, or if the projects invested in don’t bear fruit, then we can retroactively say it was bad debt. Almost a third of small businesses fail to survive their first two years, so startup money is more likely than not to eventually fall into the bad debt category.

In short, debt that allows you to control or acquire an asset that increases in value at a faster rate than the interest on the debt is likely to be good debt. Used in this way, good debt is a tool that you sometimes hear described as “leverage.”

Bad debt, on the other hand, does not enhance your financial well-being in any significant way. The “benefits” associated with bad debt tend to be mostly emotional: the thrill of gratifying “wants” that are not truly “needs.” Buying luxury items that you don’t need (think: an 80-inch TV to watch NFL games, or a very expensive automobile that also happens to be a gas guzzler) immediately fall into the bad debt category. Especially problematic are those second homes on the lakefront or in the mountains that not only put you in debt but also incur annual maintenance costs. If you want or need those things, it’s better to save for them and avoid the interest rate charges.

If too much of your available financial resources are required to keep your debt in good standing (i.e., to pay at least the minimum required monthly payments), you likely have a “bad debt” situation. If your monthly debt payments come to more than 43% of your monthly income, then it becomes a red flag to potential lenders. For instance, you probably won’t be able to get a mortgage if your ratio exceeds that amount.

What to do about bad debt

If you find yourself in the same position as my client Kathleen, formulate a plan to eliminate bad debt. Here are some suggestions for how to get started:

1. Develop a budget. If you’re starting on a trip to a place you’ve never been, the first thing you need is a good map. Similarly, the journey out of debt starts with gaining a clear understanding of your current financial situation, namely, through creating a budget. List your income in one column and your payments/debts in another. Update your budget each month to reflect your actual income and expenditures. For a good free online budgeting tool, consider Credit Karma. You can see your expenses and monitor your categorized monthly cash flow.
2. Track your spending. The next step in getting out of debt? Know where your money is going. How much of your monthly income pays for things that are nice, but not required living or work expenses? The more of these dollars that you can earmark for paying down your bad debt, the sooner you can get back on track to financial health.
3. List your revolving credit accounts, including balances, monthly required payments, and interest rate. Listing your credit card and other unsecured debt in this way will help you prioritize which accounts to pay off first, based on the method you choose.
4. Pick a “bad debt” and start paying extra on it. Too many people think that as long as they’re making the minimum required payment on their debt, they’re doing okay. Unfortunately, over time this is a recipe for accumulating too much bad debt. Whether you choose an account with the smallest balance left for payoff or one with the highest interest rate, pick an account and dedicate yourself to paying as much on it as you can each month. Reallocate some of the money you identified in Step 2 and discipline yourself to apply that to the debt, in addition to the required monthly payment. Even an extra $25 to $30 per month can make a big difference in the amount of time required to pay off the balance.
5. Make smart use of “found money.” Did you get a bonus at work? A nice birthday check from a relative? A tax refund? Plow these unexpected mini windfalls into your debt liquidation plan.
6. Consider a “snowball” payoff strategy. Once you get a bad debt account paid off, don’t let up! Take the amount you were paying on that loan and apply it to the payment on another account. Your monthly outlay stays the same, but you’re ramping up the rate at which you’re shedding the bad debt that is threatening your financial security.

At Mercer Advisors, we are dedicated to each client’s total financial picture, including helping them find the best ways to manage debt. For more information, speak with your advisor. And if you are not a Mercer Advisors client, let’s talk.

¹ “Household Debt and Credit Report.” Q4 2023 Household Debt and Credit Report, Federal Reserve Bank of New York, Center for Microeconomic Data.

² Martinez, Dan, and Margaret Seikel. Credit Card Interest Rate Margins at All-Time High, Consumer Financial Protection Bureau, 22 February 2024.