What’s the difference between good debt and bad debt?

Personal finance contributor Christopher Liew breaks down various types of debt that can work in your favour, and those that can hold you back (Getty Images / iStockphoto / Porcorex) (porcorex)

While debt often gets a bad reputation, not all debt is created equal. High-interest credit cards and payday loans can trap you in a cycle of financial stress, but certain types of debt, like a mortgage or student loan, can actually help you build long-term wealth.

The key is understanding the difference between good debt and bad debt and knowing how to use borrowed money wisely.

Below, I’ll break down various types of debt that can work in your favour and those that can hold you back. I’ll also explore some strategies to help you manage debt responsibly, so you can make informed financial decisions that support your future goals.

An increasingly debt-based society

A recent survey from credit bureau TransUnion Canada revealed that 43 per cent of Canadian consumers plan to open a new credit card in 2025 and that one in five plan to take on debt of some form.

Although the inflation rate has cooled off in recent months, many people are still struggling with higher costs of living and daily necessities, especially as wage increases seem unable to fully match recent inflation growth.

Unfortunately, for many who find themselves in a financial bind, taking on debt can seem like the only way through a difficult time.

Aside from the post-COVID ups and downs, our society as a whole has moved to become increasingly more debt-based. Twenty years ago, the average consumer may have had a car loan, home loan, and a bit of credit card debt. Today, it’s not uncommon for young consumers to have a host of debts and payments, such as:

• A cell phone device payment
• A laptop finance payment
• Car payments
• Credit card debt
• Rent-to-own furniture payments
• Student debt
• Buy-now-pay-later repayment plans

Combined, all of these can lead people to a point where they’re essentially just living paycheque to paycheque, without much room to build their savings or invest in their retirement.

Examples of good debt

Not all debt is bad, though. In fact, the ability to get into debt for good reasons can really help you get ahead in life and reach your goals faster.

Take business loans, for example. Today, thanks to modern credit reporting, it’s possible for the average consumer to apply for and receive the funding they need to start a small business, buy or build a home, or fund their higher education.

Small business loans

Many small business ideas require some type of funding to get off the ground. Depending on the type of business you plan on starting, you’ll need to purchase equipment, product stock, a work vehicle, or even to help you pay for marketing or cover payroll for the first few months of operation.

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Most reputable banks are willing to provide start-up capital to entrepreneurs, as long as they have their plan in order. While requirements vary based on the applicant and the proposed business, most lenders will want to see:

• That you have a decent credit score
• A well-written business plan
• A low debt-to-income ratio (which you can calculate here)

Typically, small business loans will come with a simple fixed interest rate, similar to a personal loan or an auto loan. With each payment you make, a portion will go to the principal balance and a portion will be paid in interest to the bank.

Small business loans are a great example of so-called “good debt.” While hiccups can certainly happen along the way, a small business loan (when combined with a solid, executable business plan) can help the borrower build a profitable and sustainable business.

Home loan

Purchasing a home can be another example of good debt. If it’s your first time buying a home, and you qualify for a CMHC-backed first-time homebuyer loan, you may only be required to put 5 per cent of the purchase price down and can finance the remainder.

As you continue to make payments, you’ll build equity (ownership percentage) in the home. Once the home loan is paid off, you’ll own your home outright. In the future, your home can also be used as collateral, making it easier to take out loans in the future. For example, a lower-interest car loan, a small business investment, or for home repairs and renovations.

Student loan debt

Getting a higher education or specialized training can be a great way to set yourself up for success in a career of your choice, allowing you to earn more income and catapult your career to new levels (or make a change in a completely new direction).

Whether you’re applying for college or a post-graduate program or paying for the training necessary to receive higher credentials, taking out a student loan to help you cover the cost of tuition, books, and living expenses can be an investment that will pay you back in the future.

Examples of bad debt

I like to define good debt as a form of debt that can help you get ahead in life – allowing you to earn more money, build your net worth, and expand your skill sets.

Bad debt, on the other hand, comes in the form of unnecessary debt or debts that are taken out of desperation to help you make it through a difficult financial time. These could include:

Credit card debt: Today, credit card interest rates are very high. This can result in credit card payments that are interest-heavy and can get consumers stuck in a position where making their minimum card payments barely makes a dent in their principal balance.

High-interest auto loans: If you have a poor credit score, are a new buyer, or have previous auto repossessions on your credit report, you may only be able to receive a higher-interest auto loan, which could lead you to paying far more for your car than it’s actually worth.

High-interest personal loans or payday loans: When taken in desperation or from a position of poor credit, payday loans, title loans, or high-interest personal loans can be financial deathtraps that lead consumers into long-term, high monthly payments. By the end of the loan term, they may end up paying back far more than they initially borrowed.

How to avoid bad debt

The best way to avoid bad debt is to live below your means and stick to a budget that gives you financial breathing room and allows you to build emergency savings. This money can be used for unexpected expenses, so you never have to apply for higher-interest, predatory loans.

This will also give you the freedom to apply for forms of good debt when the time is right or to build your credit by responsibly using a credit card (and paying it off every month) or applying for a lower-interest auto loan.

Christopher Liew is a CFP®, CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers at Blueprint Financial.