Credit and Debt: What’s the Difference?
The words “credit” and “debt” may seem interchangeable, but they are quite different.
The simple definition for debt is something owed, usually money. Credit is different in that it gives you the right, but not the obligation, to borrow funds.
Understanding credit and debt — and how you can get a better handle on both — is important to your financial health.
What is debt?
Taking on debt — typically money borrowed from an institution or another individual — comes with an obligation to repay the amount over a designated period. There are “good” debts — and there are “bad” debts.
Examples of good debts can be mortgages and student loans, provided you make regular payments. A home loan shows lenders that another institution had enough faith to lend you a large amount of money. And student loans are a good indicator of future earnings. A 2011 study by Georgetown University’s Center on Education and the Workforce showed those with a bachelor’s degree earn a median of $2.27 million over their lifetime, which is about $1 million more than individuals who only have a high school diploma.
On the other hand, a common example of a bad debt is a payday loan. This type of loan can indicate a person’s financial instability, which is something for which lenders are on alert. Some financial institutions offer loans with no collateral that have a high interest rate. If you’re stuck with loans like these, you might want to consider debt consolidation.
What is credit?
An institution approves you for a certain amount of credit that can be used to purchase goods. The most common example of this kind of revolving credit is credit cards — not to be confused with charge cards where the balance has to be paid in full at the end of the month. (Unlike an installment loan, which has a fixed monthly cost over a specific time frame, revolving credit does not have a fixed number of payments or amount, other than the monthly minimum.)
Another example of credit is a home equity line of credit. These are available to homeowners who have equity in their home and want to borrow money against the value of the home. Unlike credit cards, there is collateral on the line of credit (the house). Ideally, the funds will then be used to improve on the home, thus increasing the value.
How to improve your relationship with debt and credit
Here are some tips to reach financial stability:
- If your payment history is less than stellar, you’ll need to keep making regular payments to show that you can be more reliable.
- You don’t need to pay off all your debt, but you need to make some headway to keep your credit utilization ratio under 30%.
- If you are responsible with your credit cards but have credit lines with small limits, contact the issuer of the card. If the issuer sees that you are financially responsible with the credit it issues, it may be more willing to provide you better terms. This could mean lower interest rates to reduce payments or an increase in credit that will help improve your utilization ratio.
Having debt does not mean you are a financial risk and deserve a lower credit score. Your score comes from how you handle your debt and credit. Use them both responsibly, and you could get a higher score over time.
Let’s drill deeper into each term.
The bottom line
Knowing the difference between debt and credit can go a long way.
The word debt can evoke negative thoughts, but there are times when debt — especially with a mortgage — can put you on the right path financially. At the same time, a mortgage may not be right for your financial situation, or credit could get you in trouble if you’re not careful.
Always remember to research your options when considering loans or types of credit.