Debt isn’t inherently bad. In fact, how you manage your debt is one of the biggest contributors to your credit report and overall financial picture. Responsible debt usage can improve your income, grow your assets, and help you secure better interest rates.
However, it's important to understand the ratio of your debt to income, especially when applying for a new loan. Your debt-to-income ratio (DTI) can significantly impact your creditworthiness and financial stability.
In this guide, we’ll explore the differences between good debt and bad debt, how to calculate your DTI ratio, and how to manage your payments to avoid taking on more debt than necessary.
Good debt is debt that improves your life and future earning potential. It typically helps you build credit, increase your monthly income, or acquire assets that appreciate over time.
The key is to maintain a healthy ratio between your monthly income and your monthly debt obligations.
According to NerdWallet, examples of good debt include:
These forms of borrowing often offer lower interest rates and tax advantages, but they still require thoughtful money management and awareness of your total monthly debt payments.
Investing in education can be one of the most rewarding types of debt. Student loans help build your credit history while boosting long-term income. To manage them effectively:
Use this student loan calculator from Bankrate to plan.
Starting your own business is another investment in your future. If your business succeeds and increases your income over time, your business investments are seen as good debts.
Starting a business comes with many costs. You may find yourself dipping into savings and taking out loans to pay for:
However, if you’re wise with your money and have a keen sense of business, these debts will be repaid over time. With a little luck and hard work, your small business can transform into one of your most lucrative assets.
Purchasing a home is often the largest form of good debt. If managed properly, mortgage payments build equity and can align with your long-term financial goals.
Experts recommend your mortgage payment should not exceed 28% of your gross monthly income. According to Experian, this keeps your debt-to-income ratio at manageable levels and improves your chances of loan approval with lenders like Fannie Mae or Freddie Mac.
Related Article: How to Buy a House with Bad Credit
Bad debt includes borrowing that doesn’t improve your financial position or creates burdensome payments. These debts often carry higher interest rates, lose value over time, or lead to more debt accumulation.
Owing money to your credit card is one of the most common types of bad debt. Credit cards are issued by lenders and allow you to make purchases on credit. These cards can come with high interest rates (often with a rate of more than 20%) and can get out of hand quickly.
Learn More: Credit Card Debt Consolidation Tips
However, owning a credit card is not bad. Credit cards are one of the quickest ways to build up credit, particularly if you have none. A little discipline and strategic usage can make your credit card one of the biggest credit tools in your arsenal.
Related Article: How Many Credit Cards Should I Have?
Buying a car might seem like a worthwhile purchase, but auto loans are considered bad debt. A car’s value depreciates over time, so it’s important to know when to sell or trade in your car. Your car depreciates due to changes in:
This depreciation flushes all of the interest payments you make over the length of an auto loan right down the drain. To avoid spending more than necessary, pay as much as you can up front. Large down payments can lower your loan’s interest rates.
Related Article: How to Skip or Defer a Car Payment
Like credit cards, personal loans can push you deep into debt quickly if you aren’t careful. What you use the loans for will determine if the debt is good or bad.
Personal loans come with interest rates that are based on your credit and range from 5-36%. Unlike credit cards, they are installment loans that require monthly payments to repay the loan completely within a 2-5-year span.
Personal loans can be used for a variety of reasons, including:
Despite the risk that comes with taking on interest, there are several cases in which personal loans can be considered good debt. If you do not qualify for a business loan, personal loans are often used as an alternative. They can also be used to consolidate multiple debts into a single, manageable monthly payment.
Payday loans are one of the most notorious types of bad debt. These short-term, unsecured loans gain their bad reputation from their extreme interest rates, often running as high as 400%.
Combined with multiple service and late fees, these high rates are intended to encourage borrowers to pay their loans off as quickly as possible. Missing due dates can cause your debts to skyrocket, and you may find it difficult to gain back control.
Payday loans should be considered your absolute last option. If you are tight for cash, there are several alternatives to payday loans that you should consider first.
Learn More: What is Interest & How Does it Work?
A good debt to income is below 36% is considered ideal. For instance, if your total monthly debt payments are $1,500 and your monthly income is $5,000, your ratio is 30%.
A high DTI ratio (above 43%) can limit your loan options and raise your interest rates. Lenders may also consider your income DTI ratio and other financial obligations, such as utility bills or insurance premiums.
Use a DTI calculator to see how your debt payments compare to your income.
Even if you’ve taken on bad debt, recovery is possible. Here are proven tips:
Monitoring your DTI ratio, income growth, and spending will help you balance future debt responsibly.
Debt is not inherently negative. It becomes a problem only when it outpaces your ability to repay. Keep your DTI ratio healthy, stay alert to your credit report, and always assess whether the new debt you take on supports your goals.
If you’re feeling overwhelmed or unsure where to begin, Credit.org is here to help. Our certified counselors can work with you to:
Being in debt is not as bad as it’s painted to be. The right sort of debt can have a huge positive impact on your financial wellbeing. Even bad debts have value if handled correctly.
No matter what sort of debt you have, there is a solution for you. If you’re looking for help on how to handle your debts, talk to one of our expert debt counselors for help setting up a budget that makes paying your debts back simple and manageable.
