Debt and credit are two very different concepts. Understanding both is critical to boosting your financial stability and well-being. Here's what you need to know about each of these financial terms.
What Is Debt?
The term debt refers to money that you have borrowed. It is money you spent or obtained in some way that you have not yet paid back to the lender. For example, if you have a loan of $1,000, that is debt. You owe the lender $1,000 plus any interest on that money.
Debt is what you owe. It's what you have to pay back to the lender. Over time, the more money you borrow, the higher your debt will climb. The higher it climbs, the harder it is to repay. It's important to consider that you will pay interest on that debt if you do not repay all the money you borrow each month.
There are various types of debt that you could have:
- Secured debt: Some asset backs this type of debt. For example, your mortgage is a secured debt with your home backing up the loan. If you fail to make payment, the lender can work to foreclose on your home. Similarly, your auto backs your car loan.
- Unsecured debt: This type of debt lacks backing from any collateral. Therefore, the lender bears a higher risk since the borrower's assets do not ensure repayment.
Revolving debt is another important term. This type of debt accumulates over time, allowing a borrower to continuously draw up a certain limit from an available line of credit. A credit card is a prime example of revolving debt. If you do not fully repay your credit card balance within the billing cycle, you carry a debt that grows with interest. Nevertheless, as long as you stay within your credit limit, you can repay and re-borrow funds repeatedly.
What Is Credit?
The term 'credit' refers to an individual's capacity to borrow money. Typically, lenders assign a borrowing limit. They then apply interest to any borrowed funds, accumulating as you gradually repay them.
Creditors offer credit to consumers. The creditor will decide who can borrow from them and what they will charge that person to borrow. Creditors use a variety of factors to make these decisions, including how much income they have and how many other debts they have.
Key Differences Between Debt and Credit
Debt and credit go hand-in-hand. The difference comes down to what stage you are in:
- Credit is the loan that your lender provides to you. It is the money you borrow up to the limit the lender sets. That is the maximum amount you can borrow.
- Debt is the amount you owe and must pay back with interest and all fees.
When it comes to managing debt, consider these key factors.
- Avoid taking on more debt than you can afford to repay. Remember that borrowing money comes at a cost – in the form of interest – and adds up quickly.
- In the best situation, you should pay off all the monthly debt you build. That reduces the cost of borrowing.
- Work to keep your balances as low as possible. If the debt you owe is more than 30% of your limit, that may impact your credit score negatively.
Base your budget on your actual income. Then, use debt as limitedly as possible. That will ultimately help you save money.
Credit functions a bit differently. Possessing available credit is beneficial as it demonstrates to lenders your ability to handle your finances successfully. However, having excessive credit availability can concern some lenders, even if your current debt is low. This apprehension arises from the potential risk of you borrowing heavily at once, leading to substantial debt.
To manage credit:
- Apply for no more than one loan or new line of credit every six months.
- Keep your balances on your credit as low as possible.
- Use credit that doesn't come with fees attached, like monthly or annual fees.
Balancing credit and debt is an important part of making wise financial decisions. It's good to have available credit in case you need it and to use it to build your credit score. Too much debt, though, can be expensive and hard to manage.