The money that you borrow through a loan or by using credit is considered a debt. This is the money that a lender has loaned to you and that must be repaid according to the agreement that you made with the lender.
Debt is money that is owed to an individual or institution. Credit card balances, mortgages, auto loans and personal loans are all examples of debt.
Debt can be secured or unsecured. Secured debts are backed by collateral. Collateral is an asset the borrower owns that can be forfeited to the lender if the borrower defaults (fails to repay the loan as agreed).
Examples of secured loans include mortgages, which are backed by real estate, auto loans, which are backed by the financed vehicle, and title loans, which are also backed by automobiles. Examples of unsecured debt include credit cards and personal loans, which are backed only by the borrower’s promise to repay.
Debt comes in two versions: good and bad. Knowing the difference can make your financial life much better. Debt is a standard part of most of our lives, so it is important to have only good debt to make life easier.
Good debt comes in many forms. If you are buying a home, most likely you do not have $200,000 (or whatever the purchase price) to use cash to buy the home. Nor would it necessarily be wise to use $200,000 cash to buy a house even if you did have it. Good debt is usually considered to leave you with an asset that makes it worth the cost of getting the debt in the first place. Things such as a college education, a home, and possibly a car can all be good debt. However, even with these purchases that leave you with an asset, you still have to make sure that you get the right loan that gives you the best terms for paying off the debt.
Bad debt is what gets so many people in trouble. It involves buying things you simply cannot afford. You think that using credit allows you to “afford” it, but you are simply borrowing money from somewhere else that will have to be repaid. Also, the longer it takes you to repay, the more the item costs. This is due to the fact that you have to pay interest on purchases made with credit. Bad debt involves paying too much in interest so that the final cost of the item is much more than its original price.
Credit cards make is very easy to obtain bad debt. It can be very tempting to buy something that you want now, instead of waiting until you have saved enough to pay cash for it. Also, even some good debt can become bad if you get the wrong kind of loan. For example, a mortgage is typically considered good debt, but not if you buy more house than you can really afford and you become “house poor.”
When acquiring debt, you need to understand three things. First, know what the exact cost of the debt will be. This includes the interest on the debt. Next, understand how the cost of the debt will grow over time. A $1,000 debt may not seem like that much, but if you take too long to repay it, the interest can quickly multiply that $1,000 until it is much more than that. Finally, know that how you use credit affects your ability to use it in the future. If you use too many credit cards and maintain high balances, it can hurt your credit history and make it more difficult for you to get a mortgage some time in the future. Be disciplined in your use of debt so that you can maintain good debt and avoid the bad.