Good Debt vs Bad Debt

Not all debt is equal — here is how to tell the difference

5 min read Beginner

"A mortgage at 4% interest that funds an asset appreciating at 6% is mathematically different from a credit card at 29% funding a holiday. This chapter explains the framework for thinking about debt clearly."

For educational purposes only. Nothing in this chapter is financial advice. All figures are illustrative examples. Tax rules, account types, contribution limits, and regulations differ by country and change over time. Always verify current rules with official government sources or a qualified financial adviser before making any investment decisions.

The Interest Rate Framework

The distinction between good debt and bad debt is not about morality — it is about maths. The question is: what is the cost of this debt, and does it produce something worth more than that cost?

A simple rule: if the interest rate on the debt is lower than the likely return on investing the same money, the debt can be worth carrying. If the interest rate is higher, paying it off is the better investment. A mortgage at 4.5% against a long-run stock market return of around 7–8% is close to neutral. A credit card at 24% against any savings account is a clear loser.

The real world is messier than this — guaranteed debt repayment versus uncertain investment returns, tax implications, risk tolerance — but the interest rate is always the starting point.

Common Debts — Where They Fall

Mortgage: Generally the most benign debt most people carry. Rates in the UK typically range from 3.5% to 6% depending on the fix and the market. You are also buying an asset that may appreciate. The risk is illiquidity — your money is locked in bricks — and overextension if rates rise significantly at renewal.

Student loans (UK): Complex. Plan 2 and Plan 5 loans are written off after 30 years and repayments are income-contingent. For many graduates, the effective cost is closer to a graduate tax than a conventional debt — see the dedicated student loan chapter for detail.

Car finance (PCP or HP): Rates vary widely, from 5% on a good deal to 15%+ on subprime offers. Cars depreciate — you are financing a depreciating asset, which is the opposite of a mortgage. Not inherently bad if the rate is low and the car is essential, but never a good investment.

Credit cards: The canonical bad debt. Average UK credit card APR in 2025 is around 24–27%. There is no realistic investment that consistently beats paying off a 25% credit card. If you carry a balance, this is the first thing to eliminate.

Buy Now Pay Later (BNPL): Zero-interest if paid on time, but the structural problem is it normalises spending money you do not have. Late payments trigger fees and interest. A convenience tool that many use as a credit substitute.

The break-even test: If your debt costs more than 6–7% annually, paying it off gives you a better guaranteed return than most investments. Below 4%, the maths may favour investing. Between 4% and 7% — it is a personal judgement call based on your risk tolerance.

When Debt Actually Makes Sense

Debt makes sense when it finances something that generates returns greater than the cost of borrowing. A business loan at 7% that generates 20% return on investment is good debt. A mortgage that lets you stop renting and build equity in an asset — while potentially appreciating — is usually better than the alternative.

Debt also makes sense in emergencies, when the alternative is worse. An £800 car repair on a 0% credit card, paid off within the interest-free period, costs nothing extra and preserves your cash. The same repair on a 39% APR card that you carry for two years costs considerably more.

The worst reason to borrow is convenience — buying things you cannot afford today for consumption today. A holiday on a credit card you will pay off over 18 months is one of the most expensive ways to travel.

FAQs

Should I pay off my mortgage early or invest the extra money?

At current UK mortgage rates (4–6%), it is close to neutral against long-run stock market returns of 7–8%. Paying the mortgage is guaranteed and risk-free; investing is higher expected return but variable. Most people benefit from a mix — some overpayment for security, some investing for growth.

Is it worth taking a 0% purchase credit card?

If you pay it off before the promotional period ends, yes — it is free credit. The risk is forgetting the end date or not budgeting to clear it, at which point the revert rate (typically 24%+) kicks in on the full remaining balance.

My student loan interest is 7% — should I pay it off?

For UK Plan 2 and Plan 5 loans, probably not. The write-off after 30 years means most graduates never repay in full, and voluntary overpayments rarely make mathematical sense. The dedicated student loan chapter covers this in detail.

What order should I pay off multiple debts?

Two approaches: avalanche (highest interest rate first — mathematically optimal) or snowball (smallest balance first — psychologically motivating). Avalanche saves more money; snowball keeps more people on track. Both beat making minimum payments on everything.

Key takeaways

The interest rate on debt is the key variable — compare it to the return you could get elsewhere.
Credit card debt at 24%+ is almost always the priority to eliminate before investing.
Mortgages and low-rate loans can coexist with investing — the maths are close to neutral.
UK student loans function more like a graduate tax than conventional debt for most borrowers.
Debt makes sense when it finances something that generates more than it costs — not when it funds consumption.