HUNTSVILLE, Ala. — Debt is money a person, business or government owes to a creditor. Debt usually comes with a contract noting repayment terms, including what interest rate the borrower will pay on the debt. Often, the interest rate you're charged and the amount you're able to borrow is determined by your creditworthiness. Lenders determine creditworthiness by reviewing your credit score and borrowing history.
Debt can be necessary for major expenses, such as buying a home or a car or going to college. The key to a healthy relationship with debt is to only borrow money you're confident you can repay, and to avoid high-interest debt. Read on to learn more about what debt is, how it works and the pros and cons of taking on debt.
What is Debt?
Debt is money that is borrowed and then owed to a lender. If a debt is owed by an individual (rather than a business, for example), it's often simply called personal debt or consumer debt.
Borrowing can unlock financial opportunities, such as the ability to buy a home. There are other perks to borrowing, too, such as earning rewards on your purchases. But it's also essential to be cautious about taking on any debt. Only borrowing what you can afford and making on-time payments on the debt are key to avoiding damage to your credit and finances.
How Debt Repayment Works
Anytime you borrow money, you create debt. As a borrower, you typically agree to repay your debt according to terms and conditions noted in a contract provided by the lender. The contract will usually include a fixed or variable interest rate, fees, payment schedule, minimum payment and other information. A minimum payment is the smallest amount you can pay each month to keep your debt in good standing. For example, your student loan may have a $200 minimum payment each month.
Two key debt terms to know are "principal" and "balance." Your principal is the amount of money you initially borrow. For example, if you take out a $5,000 loan, your principal is $5,000. Your balance is how much you currently owe, and it includes both principal and interest. When you make payments on a debt, your payments typically go to interest owed before going toward your principal balance.
Good vs. Bad Debt
People sometimes refer to two types of borrowing: good debt and bad debt. In general, the difference between the two is what they get you—and what they cost you.
- Good debt helps you improve your financial position. Good debt is usually considered debt that helps you build wealth over time. For example, a mortgage is often seen as good debt because it's a gateway to building home equity, net worth and financial stability through homeownership. Student loans can be considered good debt because they are needed by many to achieve a college education and increase earning potential. Another definition of good debt is any debt that you can effectively manage or that doesn't incur interest.
- Bad debt doesn't improve your financial position. Bad debt is typically considered debt that won't generate income or appreciate in value, goes toward nonessential purchases, charges high interest, is unaffordable to you or hurts your credit. A credit card balance that you carry from month to month and pay interest on is a form of bad debt because credit cards tend to charge high interest rates. (Credit cards can also be considered good debt if managed responsibly since they offer ways to earn rewards and build credit.)
Types of Debt
There are many different kinds of debt that an individual or a business might owe. For example, a small business might take out a loan with a fixed repayment plan. Or, the business might use a business credit card to pay for expenses, running up a balance and repaying it as needed.
When it comes to personal debt, the types of credit you can access are similar. Generally speaking, you can group debt into these two categories:
- Installment debt: Installment debt is debt that's borrowed in a lump sum and repaid over a set period of time with a fixed monthly payment. The monthly payment includes both principal and interest. Examples of installment debt include personal loans, mortgages, auto loans and student loans.
- Revolving debt: Revolving debt is a line of credit that's borrowed against, repaid and used again as needed. The borrower repays the balance, plus interest, over time. Examples of revolving debt include credit cards and home equity lines of credit (HELOCs).
Within installment and revolving credit categories, here are some common types of debt individuals may utilize:
Pros and Cons of Debt
Some debt can be a good thing, and when you responsibly manage debt, you can gain access to the good without the bad. But it can also be easy to get in over your head with debt, especially if you borrow at a high rate of interest. Here's what to know.
Advantages of Debt
- Debt helps fund large expenses. The ability to buy a home, fund an education or finance a car often requires taking on debt. These purchases can make a big difference in quality of life and in some cases can help you build wealth over time, such as in the case of a mortgage.
- Debt can help build credit. A history of borrowing and responsibly repaying debt can help you to achieve a good credit score. That can make it easier to access credit with good terms when you need it, such as when you're ready to buy a home. You don't have to take on debt to build your credit history; you can use a credit card for everyday purchases or a specific monthly bill, then pay off your full balance within the grace period to build credit without paying interest.
- Debt provides access to flexible repayment. Once you have good credit, borrowing for a major purchase can allow you to spread payments out over a longer period of time. That can make purchasing something like a home appliance more manageable. To avoid paying interest, look for an introductory 0% APR credit card.
Disadvantages of Debt
- High-interest debt is expensive. The largest downside of borrowing is that if you're carrying a balance or a loan with a high rate of interest, those charges add up quickly and can create a significant financial strain. Paying interest adds to the overall cost of a purchase or expense, and it can make it more difficult to reach financial goals, such as saving for retirement. In addition, missed payments can add late fees and other penalties to your bill.
- Mismanaged debt can damage your credit. There are a few ways too much debt can hurt your credit. First, if you miss a payment or default on a loan, your credit score will take a hit. But even if you make on-time payments, racking up a large credit card balance can lead to a high credit utilization rate, which also has a negative impact on your score.
- Debt can be a major source of stress. When you're in over your head with debt, the damage isn't limited to your finances, but can also be a burden on your mental health. A majority (60%) of respondents report anxiety surrounding their finances, according to research from the Global Financial Literacy Excellence Center at George Washington University and the FINRA Investor Education Foundation. The same study found that of those with stress, high debt was a major contributing factor.
What Is Debt Consolidation?
Debt consolidation is when you combine multiple debts into one loan. There are benefits to consolidating debt. First, if you're shouldering one or more high-interest balances, debt consolidation may allow you to roll those balances into a lower-interest loan, which can lead to substantial savings while you pay off the debt.
Second, debt consolidation can make managing multiple balances easier by streamlining your payments into one fixed monthly payment. Reducing the number of payments you have to make can ease the burden on your budget and make you less likely to miss a payment.
There are also some downsides to consolidating debt, however. First, you may have difficulty qualifying for a debt consolidation loan with good terms if your credit score isn't high. Second, consolidating your debts into a new loan may free up your credit lines. If you aren't careful to get to the root cause of your debt and avoid racking up a new balance, you could end up deeper in debt.
How to Get Out of Debt
If you're paying a lot of interest on your debt, paying it off as soon as possible is a big win for your financial health. To start, take inventory of everything you owe. Then, prioritize paying off debt by creating a budget that includes debt repayments.
To decide which debts to tackle first, try a debt repayment strategy: The snowball method focuses on repaying your smallest balances ASAP, while the avalanche method focuses on paying off your highest-interest balance first. If you need assistance getting out of debt, consider nonprofit credit counseling for personalized help.
In addition to getting on top of your debt, be sure you're keeping an eye on your credit. Get your credit report for free through Experian to see where you stand now. You can also sign up for free credit monitoring to see how repaying your debt builds credit over time.