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When you're learning about money management, the words "debt" and "credit" come up a lot. While both words have to do with owing money, credit and debt are not the same.
Debt is the money you owe, while credit is money you can borrow. You create debt by using credit to borrow money. Let's say you charge $200 on a credit card with a $1,000 credit limit. You now have $200 in debt and $800 in available credit ($1,000 - $200 = $800) on that account.
Credit and debt are not the same, but together they make up an important part of your financial picture. Learning how to manage both is crucial to avoiding money troubles and achieving your financial goals.
What Is Credit?
Credit is the ability to borrow money with the promise you'll repay it later, usually with interest. You might use credit to pay for goods and services you can't pay for immediately, or to earn rewards or cash back on a credit card.
The lenders, merchants and service providers you borrow from are known collectively as creditors. Creditors decide whether to approve you for credit based on your borrowing record. If you have a reliable record managing credit, you are said to have "good credit," and creditors may consider you a creditworthy borrower.
How Does Credit Work?
Creditors evaluate your creditworthiness by examining your credit history—your record of how you've repaid debt in the past. Your credit history is detailed in credit reports that show your credit activity, including your payment history with each of your credit accounts.
Three major credit bureaus—Experian, TransUnion and Equifax—create consumer credit reports based on borrowing and repayment data that's voluntarily reported by creditors. Checking your credit reports is often one of the first steps lenders, credit card issuers and other creditors take when evaluating your creditworthiness and deciding whether to extend credit to you.
Types of Credit
There are three types of credit accounts: revolving, installment and service.
- Revolving credit: With a revolving credit account, such as credit cards or home equity lines of credit (HELOCs), you have a credit limit that you can't exceed when using the account for purchases. You can pay your balance in full or in part each month, but you must make at least a minimum monthly payment. Any balance that remains carries over to the following month.
- Installment credit: Installment credit is a loan for a specific amount of money, including interest and fees, that you repay in fixed, regular payments (installments) for a specific number of months. Common examples of installment credit include auto loans, mortgages and student loans.
- Service credit: Service credit is when you contractually agree to pay a service provider—such as a utility company, cellphone company or fitness gym—for past service. For example, your electric company provides your home with electricity, and you pay them once you receive a bill for your usage the previous month.
What Is Debt?
Unlike credit, which is money that is available for you to borrow, debt is money you've already borrowed but haven't yet paid back. Credit is merely the ability to acquire debt.
If you use your credit card to make a $50 purchase, you're adding $50 in debt. The more you purchase using your card, the more your debt grows. If you don't pay off all the debt you owe on your account, you'll usually be charged interest, which is essentially the cost of borrowing money.
Each of us can only handle a specific amount of debt based on our income, expenses and our own unique financial situation. A wise money habit is to avoid taking on unnecessary debt that you can't comfortably repay. For example, piling up credit card debt with everyday purchases can strain your budget and make it difficult to keep up with your monthly payments. Additionally, increasing your debt could negatively impact your credit score.
Good Debt vs. Bad Debt
Some debts are considered "good," particularly when they have lasting benefits. Such benefits include affordable payments and the opportunity to build wealth or improve your income. Here are a few examples of good debt:
- Mortgage loans: Mortgage debt is generally considered good debt because not only will you get value from living in the home, but the property value may also appreciate over time. As you pay off the home, you'll build equity—a value asset. Additionally, you may be able to get a mortgage to purchase an income-producing rental property. You can then add that income to your retirement savings or investment portfolio.
- Student loans: Student loans can be good debt and a wise investment in a student's future if it gives them the knowledge and skills to substantially increase their earning potential and achieve their goals.
- Business investments: Business loans allow you to start or grow a business that can support yourself and your family. Another way business loans provide value is they create an asset you can sell or pass on to your family.
Other debts do little to improve your well-being and can hurt you financially if you're not careful. Some debts make it challenging to keep up with payments and can even lead to financial hardship, such as:
- Payday loans: Payday loans are provided to borrowers in small amounts, often just a few hundred dollars. Most of the time, you must repay the loan in full within two weeks, along with a fee that can range from $10 to $30 for every $100 you borrow.
If a payday lender charges you a fee of $15 per $100, that's equal to an annual percentage rate (APR) of almost 400% for a two-week loan. In this case, if you borrow $400, you would have two weeks to pay $460 and satisfy the loan. Unfortunately, many borrowers cannot repay their loans in full and must take out additional loans to repay the original balance. These borrowers can become trapped in a cycle of debt, borrowing and repaying expensive short-term loans.
- Car title loans: Car title loans come with terms that could result in financial hardship. That's because these loans require you to hand your car title to the lenders, thereby giving them ownership of your vehicle until you pay back the loan. If you fail to make the payments, the lender can seize the vehicle and sell it. This can deal a catastrophic blow to borrowers who are struggling financially and need a car to get to work.
What Is a Credit Score?
A credit score is a three-digit number that typically ranges from 300 to 850. Credit scores provide a quick snapshot of your credit history to help creditors assess the likelihood you'll repay a debt. A higher credit score indicates you're more likely to make on-time payments than someone with a lower credit score.
Credit scores are calculated using credit scoring models, such as the FICO® Score☉ and VantageScore®. Since 90% of top lenders use FICO® Scores to evaluate your creditworthiness, your FICO® Score should give you a good sense of how lenders might view your credit.
Scoring companies such as FICO calculate your credit score using data from your credit report, including your current and past credit accounts, your record of making payments, the status of your accounts and so on.
Here's a breakdown of what makes up your FICO® Score:
- Payment history: Your payment history makes up 35% of your FICO® Score, and even missing one payment can negatively affect your score.
- Amount of debt owed: The second most important factor making up your credit score involves the amount of credit you're using compared with the amount of your available credit. This is known as your credit utilization ratio, which you can determine by dividing your total revolving credit balances by your total revolving credit limits.
So, for example, if you have a total of $1,000 in available revolving credit, and you use $250 of that amount to make a purchase, your credit utilization ratio is 25%. Creditors may view borrowers who use more than 30% of their available credit as a greater risk than those who maintain lower balances; your credit score may also suffer once you exceed this percentage.
- Length of credit history: The amount of time you've been managing credit makes up 15% of your FICO® Score. FICO factors in the age of your oldest credit account, the age of your newest credit account and the average age of all your accounts when calculating your score.
- Credit mix: Credit mix refers to the different types of credit you use, such as a credit card, auto loan, mortgage, student loan or personal loan. Credit mix, which makes up 10% of your FICO® Score, is important because it demonstrates your ability to manage a broad range of credit products.
- New lines of credit: New credit accounts make up 10% of your FICO® Score. Hard inquiries creditors make when you apply for credit also factor into your score, though a single inquiry may impact your score by just a few points. Keep in mind, having too many new accounts can harm your credit because it indicates a higher level of risk to lenders. Additionally, new accounts lower the average age of your accounts, which can also harm your score, especially if you don't have a lot of other information in your credit report.
How to Make Credit and Debt Work for You
It's always good practice to minimize your debt, but you don't have to avoid it altogether. Good debt can help you achieve personal and financial goals, such as purchasing a home or earning a college degree.
Here are some ways for managing debt responsibly:
- Check your credit reports often. You can get free weekly access to your credit reports from the three major credit bureaus at AnnualCreditReport.com through December 31, 2022. You can also check your Experian credit report and FICO® Score for free via Experian. Reviewing your credit reports often can help you spot incorrect or fraudulent items that could hurt your credit score so you can take steps to resolve them.
- Make all payments on time. Late payments can remain on your credit report for seven years, so make sure you submit your payments by the due date.
- Keep balances low. Maintaining low balances—or ideally, paying your balance in full—can help you keep your credit utilization ratio low. Scoring models measure your overall credit utilization across all your revolving accounts as well as on individual accounts.
- Don't take on too much debt. Taking on more debt than you can afford to pay back increases the likelihood you'll miss a payment or, worse, default on an account. This scenario could cause damage to your credit score, which could make it difficult to borrow down the road.
- Make more than the minimum payment. Making payments that exceed the minimum amount due helps you minimize interest charges. Additionally, using and paying off your credit card every month can put you on a path to a high credit score.
Build Credit the Right Way
Managing debt responsibly helps you build a good credit history. But if your credit journey is only beginning, getting approved for new credit accounts can be challenging. Experian Go™ can help you establish and grow your credit from the ground up. Building a positive credit history and practicing healthy credit habits can have a positive impact on your credit score.