Good Debt vs Bad Debt

What is Good debt?

Good debt is typically any debt that is considered secured. This means mortgages, second mortgages, home equity lines of credit, auto loans, and any other loan or line of credit that is secured to property.

What is Bad Debt?

Bad debt is typically anything considered to be unsecured debt. This includes credit cards, unsecured lines of credit, personal loans, etc. They’re considered bad debt because unlike secured loans they are not tied to any collateral. Since they are not tied to any collateral they are riskier lines of credit to give to consumers and therefore are viewed as negatively with regards to credit.

Lenders like to give out a diverse group of different financial products/services. However, they still often prefer risk averse secured loans above most others. Whenever property is tied to a loan it’s always a plus for the creditor. Anytime a borrower fails to repay what they borrowed, the lender can come and repossess the property or put it up for auction. This way, the lender has an asset they can seize if the borrower were to default.

Risk Averse Nature

By default lenders have a risk averse nature. Their go to move is to always give out the least risky loans as possible and maximize profit. The best quality loans are always those that have the highest chance of repayment. This is the case because regardless of what repayment plan there is, when a creditor is repaid the terms of the loan they are guaranteed profit. If they give out loans that don’t get repaid, they will lose more money and their profit generating mechanism will fail. This is why during the great recession, banks that were considered too big to fail needed to be bailed out. The fallout of plummeting asset prices on secured loans would’ve have shocked the U.S. Banking system to the point where the entire banking system could’ve collapsed.

Lenders always try to be risk averse by nature whenever possible. Secured loans are almost “guaranteed profit” the moment they agree to the terms of the loan. The only way they aren’t is if, they default and the value of the asset becomes less than the value of the loan. This was a small part of the problem during the Great Recession. The assumed “guaranteed profit” was taken for granted. Although the “true” problem stemmed from the packaging of “bad subprime debt” into mortgage backed securities and a few other things, anytime “profit” is assumed, trouble tends to brew.

Terms of the Loan

Borrowers with good credit will obviously get better lending opportunities than those that don’t have good credit. When they apply for credit, they will naturally get better offers because creditors perceive them as a better credit risk. The better the terms of the loan the more money the creditor will save on interest. The better the terms of the loan the less total interest that will be paid to the creditors.

Why Is Bad Debt Bad?

It might seem a little strange to consider debt as “bad” or “good”. Well there a few reasons for this being the case. The first reason is that these types of accounts tend to have a more negative impact to a consumer’s credit worthiness. The second is that they are unsecured. When lines of credit are unsecured they tend to not be for a specific “purpose”. When the loans or lines of credit are unspecified they are just looked as more negatively. Finally, anytime a line of credit is provided to a consumer with no collateral the loan is a higher chance of the loan going unpaid.

Why Is Good Debt Good?

Anytime money is lent with a purpose or for a specific use case and is secured to that property, the loan is going to be considered “good”. For example, if you take out a loan on a home, the money has a purpose and the loan is going to be secured with that home, so if anything were to happen the home would go into foreclosure. This is why secured debts with a purpose are considered “good debt” with regards to credit.

Nobody wants to have to take out loans or debt if they don’t have to but it’s important to the know the differences and why they occur as they do.