Good debt vs bad debt

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Not all debt is bad. Some can improve your credit score and help you qualify for better interest rates in the future. So what does bad debt mean? Bad debt offers little long-term value, and is often used for impulse buys or other unnecessary expenses. In this guide, we’ll help you tell the difference between good vs bad debt and explore ways to manage your debt more effectively.

A simple way to differentiate good debt from bad debt is to consider how manageable it is. Good debt is usually easier to handle. You might use it for regular expenses, showing to banks and other lenders that you’re a responsible borrower and able to make the monthly payments on time.

Bad debt, however, tends to have less favourable and sometimes unrealistic repayment terms. Loans or credit cards in this category often have some of the highest interest rates or APRs (annual percentage rates). People occasionally turn to bad debt when they’ve run out of other options, even using it to pay off existing debt. This cycle can make bad debt hard to escape.

When comparing good debt vs bad debt, it can be useful to ask, “Does this debt bring me value?” Good debt can help bring you closer to your important goals, like buying a house or funding education, and can even build your wealth over time. Bad debt, on the other hand, usually takes you further away from your financial goals.

The information provided here is for informational and educational purposes only and does not constitute financial advice. Please consult with a licensed financial adviser or professional before making any financial decisions. Your financial situation is unique, and the information provided may not be suitable for your specific circumstances. We are not liable for any financial decisions or actions you take based on this information.

You can find different definitions of bad debt depending on who’s taking it on. For some businesses, bad debt refers to an amount of money that’s owed to them but is unlikely to be recovered. For example, a small business might supply goods to a client on credit, only to have the client file for bankruptcy and be unable to pay the invoice.

Bad debt means something more subjective when it comes to individuals. You might take on debt for something that either doesn’t add value to your life or makes your financial situation worse. As an example, using a credit card for something you want but don’t really need might make you feel good for a short time, but the long-term effects are usually negative. Thanks to the high interest rates, you can end up spending far more than the item is worth. Over time, the amount you owe can snowball, and you end up unable to save or invest your money.

Because everyone’s priorities are different, it can be hard to define bad debts precisely. For example, while a car loan might come with high interest rates, it could be worth it if the car helps you commute to a new job.

Bad debt often goes towards depreciating assets, like a brand-new car that loses value the moment it leaves the showroom. Other common examples include:

• High-interest personal loans – These loans come with higher interest rates than other types. Borrowing money for discretionary spending, for example, a holiday or a new gadget, can leave you repaying more in the long run. However, personal loans can sometimes be used for consolidating debt, which is where you put all your outstanding loans into one loan. In this case, it would ultimately bring value and is an example of “good debt”.
• Credit card debt – One of the most common examples of bad debt in Ireland, credit cards often have some of the highest interest rates around, so if you carry a balance from month to month, the interest will quickly grow. Of course, if you use a credit card responsibly and repay your balance each month, this wouldn’t be seen as bad debt.
• Payday loans – Payday loans come with exorbitant interest rates. They’re often marketed as a quick fix when you urgently need money, but they tend to trap borrowers in a cycle of debt. Ideally, payday loans should be avoided unless there’s absolutely no other option.

Any businesses that offer credit to their customers can be affected by bad debt, which is essentially money owed that cannot be recovered. This can be due to a customer becoming bankrupt or insolvent, or refusing to pay due to disputes over the quality of goods or services provided.

When a business determines that a debt is uncollectible, it is written off in the accounting records. This involves transferring the amount from accounts receivable to a separate bad debts account.

In Ireland, businesses can claim VAT (value-added tax) relief on bad debts if they have already accounted for VAT on the unpaid amount, and they have made several attempts to collect the debt, such as contacting the customer or using a debt collection agency. This relief is claimed by adjusting the VAT return for the period in which the debt is written off.

Because “good debt” can be subjective, there are some grey areas when defining it. Good debt is typically used to help you reach important goals or increase your income. It can feel like a financial burden at first, but the idea is that you’ll be better off in the long run. And when you’re making payments on time and using the credit responsibly, this will show lenders you’re a sensible borrower, which can reflect positively on your credit score.

What counts as good debt can differ from person to person, but ultimately, it should be used for a meaningful purpose that improves your life in some way, whether financially or personally. When comparing good debt vs bad debt, you can see that good debt tends to increase in value over time. Here are a few common examples:

• Mortgage – A mortgage is often the largest loan most people will take out. But because property generally appreciates over time, mortgages are considered good debt. As you pay it off, you build equity in your home, which is a form of wealth building. Plus, with careful planning, you can save for a deposit so you’re not laden with debt before you even start making payments.
• Business loans – Starting your own business often requires an initial investment, and ongoing lines of credit may be needed to keep it running. If it’s used to grow a sustainable business that benefits you, your employees, and the local economy, a business loan is considered good debt.
• Interest-free or low-cost loans – Not all loans come with high interest rates. In Ireland, the SEAI grant offers low-cost loans to improve the energy efficiency of your home. You can use the grant to add insulation or install a heat pump, among other things. This is good debt because, in addition to increasing your home’s value, it helps you save money on energy bills and makes your home more comfortable

Good debt is really only beneficial if it stays manageable. If you borrow more than you can afford or fall behind on repayments, it can quickly turn into bad debt. For example, a mortgage might stop being “good” if the loan amount is too high or the interest rate makes monthly payments unmanageable. Similarly, if your mortgage eats up so much of your income that you’re left living pay cheque to pay cheque, you’re in a vulnerable position that could push you into bad debt territory.

If you’re unsure how to pay off debt – good or bad – you could start by listing your existing debts, the rates you’re paying, and the remaining balances. This gives you a clear picture of how much money you owe to whom, and can help you decide which debts to tackle first. If you’re unsure of the details, you can check your credit report through the Central Credit Register.

You might consider where your debt falls across the good debt vs bad debt spectrum. Since high-interest debts often make up most bad debt, you might consider paying those off first to stop interest from accumulating. Another option is debt consolidation, where your existing debts are combined into a single loan with a lower interest rate. This can simplify your payments and make debt management easier.

To avoid bad debt in the future, take a moment before applying for a loan or credit card. Ask yourself: “Does this purchase add long-term value, or is it something I want but can’t afford?” Adopting good money habits can also help. Some people like to use a budgeting method to prevent them spending more than they earn. You can also work on improving your credit score by keeping your credit utilisation low and paying your bills on time.

Putting some savings in an emergency fund is a way to avoid reaching for credit cards when those unexpected expenses come around. And once your debt is cleared, you might consider putting money into a high-yield savings account to build a safety net for the future.

Once your debt is paid off, you might start looking to get more from your money. One way to do that is by comparing savings accounts to find the best rates. If you’re ready to start, applying to open a savings account is quick and easy. Simply register for a free Raisin Account, log in, and apply today. With Raisin Bank, you’ll gain access to competitive interest rates from a variety of banks across the EU.