What are Good Bad and Beutral Debts

You may not realize it, but not all debts are the same. Broadly speaking, debt can be classified into three different types; ‘bad debt’, ‘good debt’ and ‘neutral debt’. Being able to differentiate between these different ‘debt categories’ can help you to overcome your debt problems and move a step forward towards ensuring future financial security.

The term ‘consumer debt’ (often referred to as ‘bad debt’) refers to all debts incurred to purchase goods and services, such as clothes, food and vacations. Consumer debt is typically the result of money borrowed (in large part through credit card use) in order to finance perishable items. Personal loans are also a form of consumer debt. Since the value of consumer products generally depreciates over time, most consumer debt is not backed by collateral. Interest rates on this type of debt are always high, meaning that the borrower pays much more for an item than what it is really worth. In addition, interest on many kinds of consumer debt (credit card debt and title loans, for example) is often variable and, for the most part, it is not tax deductible.

Non-consumer debt, as opposed to most consumer debts, is usually backed by some kind of asset, such as a home. The most significant difference between consumer and non-consumer debt is that the latter is used to pay for things that will increase in value. For this reason, non-consumer debt is sometimes called ‘good’ debt. Non-consumer debt also generally has a set term of repayment (ranging from months to years) and the interest on this ‘debt category’ is often tax deductible. Federal student and business loans (in reasonable amounts) are examples of ‘good’ non-consumer debt. They can serve to increase income – especially when they also cost less (have lower interest rates and are tax deductible).

In addition to the two debt categories explained above, some experts add a third category – ‘neutral debt’. These are debts incurred to acquire items or services whose value is not expected to either appreciate or depreciate significantly. Consolidation and retirement plan loans as well as certain kinds of medical debt may be classified as ‘neutral’ debts. Private student loans are also included in this category because they usually have high (and variable) interest rates and they do not benefit from the same income-based repayment plans and forgiveness laws as federal student loans.

While it may be true that some types of debt may be ‘better’ than others, they all have one thing in common – you must pay them back. If you are already deeply in debt, the above information may be useful to help you plan which debts to pay off first. Those of you who are presently considering taking out loans should remember to borrow only what you really need and can realistically afford to repay. For example, a mortgage debt should never be in excess of 30% of your income, car loans should never amount to more than 10% of your income and the amount of your entire student loan should not be more than the amount you can realistically expect to earn over one year after you graduate.