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 refer to loans that are predatory, unaffordable, or otherwise detrimental to the borrower’s financial health. Here are some key characteristics of bad loans:
-
Excessively high interest rates Loans with APRs exceeding 36% are generally considered predatory. The higher the interest rate, the harder it is to pay down the principal.
-
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.
-
Lack of underwriting: Reputable lenders thoroughly vet borrowers to ensure they can afford repayment terms. Bad loans often skip this important step.
-
Puts collateral at risk: Bad loans may use critical assets like your home or car as collateral. Defaulting could result in repossession.
-
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
-
Hurts credit: Late and missed payments on bad loans quickly trash your credit scores, limiting access to better loan options.
-
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:
-
Check interest rates and fees: Compare offers from multiple lenders and calculate the true cost of any loan to identify bad deals.
-
Read the fine print: Scrutinize the full terms and conditions to spot red flags like prepayment penalties, balloon payments, or mandatory arbitration clauses.
-
Consider alternatives: Explore other financing options like secured credit cards, low-rate personal loans, credit union lending, or borrowing from family.
-
Improve credit: Building your credit scores over time opens the door to prime loans with favorable rates and terms.
-
Save for large purchases: Setting aside funds in advance lets you avoid financing costs and loans altogether on big buys.
-
Use lending transparency tools: Resources like the CFPB’s Paying for College and Auto Loan Shopping Sheet help demystify loan details.
-
Consult an advisor: Speaking to an accountant or financial advisor can provide guidance on smart borrowing strategies for your situation.
-
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:
-
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.
-
Cash-Out Mortgage Refinancing: Tapping home equity via refinancing is less risky than bad loans if you have significant equity available at low rates.
-
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.
-
Secured Installment Loans: These loans use collateral you own to secure better rates and terms than unsecured bad loans but risk assets if defaulted.
-
Credit Union Loans: Nonprofit credit unions focused on members often offer personalized service, reasonable rates, and loan flexibility.
-
Employee Loan Programs: Some employers provide low or no-interest loans as a benefit. Repayment is deducted from your paycheck.
-
Borrowing from Family/Friends: For trustworthy borrowers, private personal loans from relatives or friends may provide flexible, interest-free ways to borrow.
-
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.
-
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: A financial counselor or financial therapist could be a good option if youre struggling to control your spending or want to better understand your relationship with money.
- Nonprofit credit counseling agencies: Credit counselors can help you create or optimize your budget. If youre overwhelmed by unsecured debt, such as credit card debt, they also might be able to set you up with a debt management plan (DMP). With a DMP, the counselor might be able to negotiate to help you save money, lower your monthly bills and get on a manageable path toward paying off the debt.
- Financial assistance programs: A financial assistance program might help you lower or pay for necessary expenses, such as utilities and food. You can then use the savings to pay down debts.
Examples of Bad Debt
Some common examples of bad debt include:
- Credit card debt: Credit cards often have high interest rates, so carrying credit card balances (instead of paying them off each month) could be considered bad debt.
- High-interest loans: Loans that have unusually high fees or interest rates include high-rate installment loans that you find online, payday loans and auto title loans.
- Debt for discretionary spending: Taking out a loan to pay for a vacation, designer clothing, hobbies or other discretionary spending could be considered bad debt.
Its often best to avoid certain types of loans and borrowing money when you dont need to. Otherwise, you could wind up in a debt cycle, where you have to continually take out new loans to afford all 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. You also might get a card that has a 0% intro APR offer and you can pay off your purchase over time without paying 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 it might be considered bad debt if youre borrowing money to buy a second car or a boat, and the loan payments make covering your day-to-day expenses difficult.
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?
High-interest loans — which could include payday loans or unsecured personal loans — can be considered bad debt, as the high interest payments can be difficult for the borrower to pay back, often putting them in a worse financial situation.
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. Business bad debts can include loans to clients, suppliers, distributors, and employees, as well as credit sales to customers.
What makes a loan bad?
Bad loans are loans in which the borrower defaults because they have not made their scheduled payments for a predetermined 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.