How good debts and bad debts can affect your credit score

The idea that there is “good debt” and “bad debt” can sometimes be hard to understand, especially if you’re trying to assess your own finances or make important decisions on how to spend your money.

Both good and bad debt can impact your credit score. While owing debts (of any kind) won’t necessarily give you bad credit automatically, how you manage the repayment of the debts can make a big impact.

Always remember to assess your own financial situation, and to think about whether any debt, good or bad, may help you achieve your personal goals.

What is good debt and bad debt?

Put simply:

• “Good debt” is borrowing to buy something that may deliver future value or benefits,
• “Bad debt” is borrowing to make one-off purchases that may not give you back much in return.

What are some examples of good debt?

Home loans are often considered to be ‘good debts’. You may borrow a lot of money and pay a lot of interest over the mortgage term, but you’ll have a home of your own to live in, or an investment property that can earn you income and/or provide tax benefits. Plus, the value of your property could potentially rise over time, growing your equity.

Borrowing money to invest in shares or to start a business, could be considered good debt, as you may be able to earn a return on these assets (though every investment is a risk, and should be carefully considered).

Borrowing to pay for education could also be considered good debt, as this could help you secure a better job.

What are some examples of bad debts?

The go-to example of bad debt is typically a credit card. While carefully-managed credit card debt can be useful for handling everyday expenses, missed repayments can lead to interest charges, which can build over time until they’re more than you can comfortably afford to repay.

Some personal loans could be considered bad debts. Your loan may help you pay for a holiday or a wedding, but you’ll be paying interest charges for the rest of the loan term without receiving returns beyond fond memories and insta-worthy photos.

Car loans could be considered good debts or bad debts, depending on your point of view. On one hand, owning a vehicle can greatly enhance your lifestyle, and can potentially be used for work. On the other hand, vehicles are typically depreciating assets, meaning they’re likely to decrease in value over time.

Before taking on any type of debt, it’s important to consider your financial situation, and to think about whether this debt may help you achieve your personal goals.

How can good and bad debts affect your credit score?

Owing debts doesn’t automatically give you bad credit. If you’ve been keeping up with your repayments (including on Buy Now Pay Later services) and haven’t over-borrowed, a good debt may actually help improve your credit score, as it adds to your credit history by showing that you’re responsible with money.

However, if you’re struggling to keep up with the repayments on your bad debts, or you make multiple credit applications over a short period of time, a lender may be less inclined to lend you more money. You may be charged higher interest rates for a loan or even see your credit applications declined altogether. Multiple loan rejections can quickly lower your credit score, making it much harder to borrow money in the future.

Finding ways to clear some of your bad debts may be able to help improve your credit score over time. You may be able to use a balance transfer credit card or a debt consolidation loan to make progress towards paying off your outstanding debts, then you could look into reducing your credit limit or cancelling credit cards you don’t need.

Checking your credit score for free may be able to get you started working out the best way to manage your debts. If you need more help, consider contacting an accountant or financial adviser, or call the National Debt Helpline on 1800 007 007.