Good debt is debt that you take on to achieve meaningful growth in your personal life or finances, like a mortgage or student loan. Bad debt is relatively expensive debt and debt that someone takes on for unnecessary expenses, like credit card debt.
Some people consider any debt to be bad. Others take a more nuanced approach. You might categorize debt as either good or bad depending on how youre using the money you borrow, the terms you receive and how the debt could benefit you.
Heres what to know about good debt versus bad debt and why understanding the differences between the two could help your long-term financial health.
Taking out a loan can be a great way to finance large purchases or investments. However, not all loans are created equal. Some loans can end up doing more harm than good if you’re not careful. So what exactly makes a loan “bad”? Keep reading to learn more about bad loans and how to avoid them.
What Are Bad Loans?
Bad loans are loans that are unfair, too expensive, or hurtful to the borrower’s finances in some other way. Here are some key characteristics of bad loans:
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Excessively high interest rates: loans with APRs above 16% are usually seen as predatory mortgages. It takes longer to pay off the principal when the interest rate is high.
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Fee-laden: Bad loans often come loaded with high origination fees, prepayment penalties, and other tacked-on costs that make the loan even more expensive.
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Lack of underwriting: Reputable lenders check out borrowers carefully to make sure they can pay back the loan. Bad loans often skip this important step.
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Puts collateral at risk: Bad loans may use critical assets like your home or car as collateral. Defaulting could result in repossession.
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Designed to trap borrowers Terms like balloon payments and short repayment periods are crafted to make borrowers fail so lenders can collect more interest and fees
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Hurts credit: Missed or late payments on bad loans can quickly hurt your credit score, making it harder to get better loans.
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Used for non-assets: Borrowing to pay for depreciating assets like vacations or electronics can lead to a dangerous debt cycle.
If a loan has one or more of these hazardous characteristics, it’s best to explore other financing options if possible.
Examples of Bad Loans
Now that you know what defines a bad loan, let’s look at some common examples:
Payday Loans
Payday loans provide fast cash until your next paycheck in exchange for fees and triple-digit APRs. The typical $15-$30 fee per $100 borrowed equates to a 391% average interest rate. These ultra-short-term loans trap many borrowers in rolling over debt.
Car Title Loans
Car title loans use your paid-off vehicle as collateral. They seem appealing because they require no credit check, but average 300% APRs. About 20% of borrowers have their cars repossessed when they can’t repay these risky loans.
Pawn Shop Loans
At pawn shops, you receive a cash loan using an item of value as collateral. You’ll need to repay the loan, plus fees and interest as high as 240%, within 30-90 days to reclaim your item. Defaulting means forfeiting your collateral.
Rent-to-Own Agreements
Rent-to-own stores let you pay for items in installments. But their financing carries effective APRs over 100%. You pay far more than retail price and the item can be repossessed if you fall behind on payments.
401(k) Loans
Borrowing from your 401(k) seems convenient, but impedes retirement savings. If you leave your job, the loan likely must be repaid in full immediately or it’s treated as a withdrawal, incurring taxes and penalties.
Credit Card Cash Advances
Cash advances from credit cards provide instant cash, but accrue interest immediately with no grace period. Fees typically apply too, making the APR on cash advances much higher than on purchases.
Online Payday Lenders
Online payday loans work like traditional storefront loans but can be even riskier since they’re unregulated in many states. Hidden fees are common and rollover coercion often continues automatically.
By recognizing these and other potentially predatory lending practices, you can steer clear of bad loans and seek out more reputable financing options.
How to Avoid Bad Loans
When you need funds for a large purchase, unexpected bills, or other expenses, bad loans aren’t your only choice. Here are some tips for avoiding bad loans:
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Check interest rates and fees: Compare offers from multiple lenders and calculate the true cost of any loan to identify bad deals.
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Read the fine print: Scrutinize the full terms and conditions to spot red flags like prepayment penalties, balloon payments, or mandatory arbitration clauses.
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Consider alternatives: Explore other financing options like secured credit cards, low-rate personal loans, credit union lending, or borrowing from family.
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Improve credit: Building your credit scores over time opens the door to prime loans with favorable rates and terms.
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Save for large purchases: Setting aside funds in advance lets you avoid financing costs and loans altogether on big buys.
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Use lending transparency tools: Resources like the CFPB’s Paying for College and Auto Loan Shopping Sheet help demystify loan details.
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Consult an advisor: Speaking to an accountant or financial advisor can provide guidance on smart borrowing strategies for your situation.
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Create a budget: Having a budget helps ensure you only take on loan payments you can realistically afford based on your income and expenses.
With vigilance and prudent financial habits, you can achieve your goals without resorting to potentially harmful bad loans. Carefully weighed borrowing done right can build assets and credit over time.
Alternatives to Bad Loans
When an emergency or necessity arises and bad loans aren’t an option, you still have alternatives to secure responsible financing:
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401(k) or Pension Loans: Borrowing against your own retirement savings avoids credit checks and is safer than third-party bad loans if repaid promptly.
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Cash-Out Mortgage Refinancing: Tapping home equity via refinancing is less risky than bad loans if you have significant equity available at low rates.
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Low-Rate Credit Cards: Balance transfer or introductory 0% APR cards can provide short-term financing without the risks of bad loans but require good credit.
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Secured Installment Loans: These loans use collateral you own to secure better rates and terms than unsecured bad loans but risk assets if defaulted.
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Credit Union Loans: Nonprofit credit unions focused on members often offer personalized service, reasonable rates, and loan flexibility.
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Employee Loan Programs: Some employers provide low or no-interest loans as a benefit. Repayment is deducted from your paycheck.
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Borrowing from Family/Friends: For trustworthy borrowers, private personal loans from relatives or friends may provide flexible, interest-free ways to borrow.
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Peer-to-Peer Lending: Online peer lending networks like Prosper and LendingClub connect individual investors and borrowers directly for personal loan terms often below traditional rates.
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Community Loan Funds: Nonprofits like Community Development Financial Institutions offer programs geared toward underserved groups who may struggle to secure affordable, fair credit.
While not without some trade-offs, these options provide more prudent alternatives to predatory bad loans for qualifying borrowers in need.
The Bottom Line
Bad loans should always be considered a last resort because of their steep long-term costs. Carefully evaluating the risks and shopping around for the most favorable rates and terms can help you avoid financial pitfalls. Seeking guidance and considering all your borrowing alternatives before taking the bad loan path can put you in a much stronger financial position.
Look for Support
Find professional help if youre unsure of what to do or you cant make your budget add up.
- Financial therapist or counselor: If you’re having trouble controlling your spending or want to learn more about how you relate to money, a financial therapist or counselor might be a good choice.
- Credit counselors at non-profit credit counseling agencies can help you make or improve your budget. They may also be able to set you up with a debt management plan (DMP) if you have a lot of unsecured debt, like credit card debt. The counselor may be able to work out a DMP that will help you save money, lower your monthly bills, and get on a more manageable path to paying off your debt.
- programs that help people get money: These programs can help you pay for or lower the costs of things like food and utilities. You can then use the savings to pay down debts.
Examples of Bad Debt
Some common examples of bad debt include:
- If you carry a credit card balance instead of paying it off every month, this could be seen as bad debt because credit cards often have high interest rates.
- Some loans, like high-rate installment loans you can find online, payday loans, and auto title loans, have fees or interest rates that are very high.
- Take out a loan to pay for a vacation, designer clothes, hobbies, or other spending you don’t have to. This could be considered bad debt.
Its often best to avoid certain types of loans and borrowing money when you dont need to. If you don’t, you might get stuck in a cycle of debt where you keep getting new loans to pay your bills.
Sometimes, debt falls into a gray areaâits not quite good or bad.
For example, credit card debt is often considered bad debt. However, you wont have to pay interest on your purchases if you pay your credit card bill in full each month. Additionally, you could obtain a credit card that provides a 0% introductory APR offer, allowing you to pay for your purchase over time without having to pay any extra fees or interest. Debt that doesnt accrue interest generally falls under good debt.
Buy now, pay later (BNPL) plans could also be good debt because they let you pay off purchases without any added interest or fees. But taking on too many BNPLs or using BNPLs to purchase things you couldnt otherwise afford could lead to trouble.
Even a vehicle loan could be in the gray zone. It might be considered good debt if you get a low interest rate and use the loan to purchase a primary vehicle. But you might have bad debt if you borrow money to buy a second car or a boat and the loan payments make it hard for you to pay for everyday things.
Often, the specific terms, how youre using the money and the entirety of your financial situation determine if a new debt will be good or bad.
What is Considered Bad Debt? | Phil Town
FAQ
What is considered a bad loan?
Payday loans, personal loans with no collateral, and other loans with high interest rates can be seen as bad debt because the high interest payments can be hard for the borrower to make, which can make their financial situation worse.
What kind of loan should you avoid?
Title loans allow you to borrow money by using your car as collateral. If you fail to repay the loan, the lender can take your car. Reasons to Avoid: Risk of Losing Your Car: The biggest risk is losing your vehicle if you can’t repay the loan on time, which can be devastating if you rely on your car for transportation.
What is an example of a bad debt?
Bad debt refers to money owed to a business or individual that is unlikely to be collected. Examples include credit card debt, high-interest loans like payday loans, and debt used to finance non-essential purchases. There are many types of business bad debts, such as credit sales to customers and loans to customers, suppliers, distributors, and employees.
What makes a loan bad?
Bad loans are loans that the borrower doesn’t pay back because they haven’t missed their payments for a certain amount of time. Although the specifics of a loan’s Non – Performing status can vary, “no payment” is typically described as a failure to pay either the principal or interest on a loan.