We often use “debt” as a blanket term to express an amount someone owes. But two people with the same amount of debt may be facing vastly different financial circumstances, despite seeming to be in the same boat at first glance based on their total outstanding accounts. The path forward will look quite different for someone with $50,000 left to pay on a mortgage than it will look for someone with $50,000 in credit card balances and personal loans.
Nuance is key when you’re dealing with debt. A good jumping-off point is distinguishing between various types so you can make a decision on how to act prudently depending on your circumstances. After all, there’s no universally “right” way to tackle debt.
Let’s start by looking at the difference between efficient and inefficient debt.
The Good: Efficient Debt
While any type of debt has the potential to usher in financial consequences for its holder, efficient debt — also known as “good” debt — can produce a positive return on investment.
A classic example of efficient debt is a mortgage, which can generate financial gains for borrowers in a few different forms. The value of the property will hopefully increase over time, leaving the buyer in a better financial position than if they were renting. Another way some borrowers leverage their investment in a home is by turning it into a rental property to generate passive income.
Some experts would consider student loans another example of efficient debt because attaining higher degrees can help graduates earn more money throughout their careers. Of course, it’s always important to weigh both the pros and cons of taking on educational debt before doing so.
Just because a type of debt falls into the category of “good” doesn’t mean it’s a sure bet. Even efficient debt represents a certain amount of risk; falling behind on payments can lead to the repossession of certain assets or damaged credit history.
The Bad: Inefficient Debt
Inefficient, or “bad” debt, is marked instead by its lack of long-term value to borrowers.
As Bankrate outlines, credit cards are perhaps the most infamous example here. Why? Because, in addition to carrying high average interest rates, credit cards often finance nonessential purchases or items that will quickly go on to lose their value. This can fuel a vicious cycle in which consumers feel they have no choice but to keep putting purchases on credit to stay afloat but have little to show for it besides growing interest and stubborn account balances.
Interest charges can easily start to command most, if not all, of cardholders’ monthly payments without actually bringing the principal balance down at all. This makes it difficult for borrowers to put a real dent in what they owe. In fact, hundreds of thousands of Americans have even undergone debt settlement through organizations like Freedom Financial Network as a result of out-of-control credit card debt — and many more have even had to file for bankruptcy.
Personal loans are another potential example of inefficient debt, although it depends on how they’re used. There are often benefits to taking advantage of personal loans for a specific goal — like making home improvements or consolidating other costlier debts. But using a personal loan to fund discretionary purchases can leave consumers with little more than some memories and a multi-year loan left to pay.
Efficient debts are a means to an end. Inefficient debts foot the bill for purchases whose value will dissipate quickly, which can leave people in a financial bind after the fact. While it’s important to evaluate every debt before taking it on, it’s especially important to be critical of “bad” debts.