Learn to tell the difference between “better” and “worse” debt so you know when it’s smart to borrow – and which debts are best avoided.
Debt: The Basics
Debt is the amount you owe to creditors for goods and services that you buy now and promise to pay for later. When you incur debt, you are borrowing money from a lender who charges you interest or fees to use the funds. This concept is important to understand since interest costs you money!
Types of Debt
There are many kinds of debt, but the most common examples are secured debt like a mortgage or auto loan and unsecured debt like a credit card balance or a student loan. Not all debt is created equal, so financial experts suggest focusing on “better” debt if you must borrow.
The amount you borrow is backed by collateral; if you fail to repay the debt, the lender takes possession of your collateral to get their money back; auto loans and mortgages are examples of secured debt.
The amount you borrow is NOT backed by collateral. Lenders consider these loans to be riskier and normally charge higher interest rates. Credit cards, student loans, and personal loans are examples of unsecured debt.
Borrowing money to purchase an asset you expect to increase in value over time, like a home, could be considered a good use of debt. A student loan to finance a college degree could also be considered a “better” debt if the degree leads to higher income.
Borrowing money to purchase something that will NOT increase in value could be considered a poor use of debt. Carrying a high-interest credit card balance or buying a depreciating asset such as a vehicle will normally fall into this category.
I’m buying a brand-new truck because I can make the payment, even though it takes up 50% of my monthly take-home pay.
I bought a certified used car with low miles to get back and forth to work. It’s not my dream car, but it fits into my budget and long-term goals.
A band I really like is coming to town and tickets are $200 each. I don’t have money saved, but I can put it on my credit card and figure it out later.
I have a credit card that I use for my purchases, then I pay my balance in full every month.