Credit is how much you can borrow, while debt is how much you owe. You’ll often find the two terms discussed together because they’re connected — using credit creates debt.
The better you are at managing debt, the more credit you’ll have access to in the future — that’s why it’s so important to understand the difference between debt versus credit.
What is debt?
Debt is owing money to someone or something. Typically, when you have debt, you’re paying interest to a creditor. That’s not always a bad thing, though, as debt can take many forms.
- Candace has a $200,000 mortgage on her home and $10,000 in student loans. She also has an auto loan for $15,000. Candace has $225,000 in total debt.
- Marco has $5,000 in credit card debt and a $3,000 personal loan. Marco has $8,000 in total debt.
- Ty has a $10,000 auto loan, $2,000 in credit card debt and owes the local hospital $3,000 for an emergency room visit. He has $15,000 in total debt.
As you can see from the examples above, people can have several different types of debt. Some types of debt are considered “good debt” and some are considered “bad debt.” We’ll go into more detail about good and bad debt later.
What is credit?
Credit is the ability to borrow money with the understanding that you’ll pay the lender, merchant or service provider back later. If you don’t have enough cash to buy a home or a car, or to pay an unexpected bill, credit allows you to take on debt. In that way, credit is convenient. But credit can also get you into trouble if you take on more debt than you can afford to repay. It can also get you stuck in a cycle of debt if you rely too much on high-interest credit cards or payday loans.
Credit comes in two main forms: secured and unsecured:
- Secured credit requires some sort of collateral to back the loan, such as your home or a car. If you default on the loan, the lender has the right to take your collateral. Because collateral lowers the lender’s risk, you may find secured credit is easier to qualify for and may come with better terms than with unsecured credit.
- Unsecured credit isn’t attached to any collateral, so lenders will rely heavily on your credit health and finances to determine your eligibility.
- Secured credit: Mortgages, auto loans, home equity loans, home equity lines of credit, secured credit cards, title loans
- Unsecured credit: Credit cards, student loans, personal loans, medical debt
What is the relationship between debt and credit?
The relationship between debt and credit is unique because one cannot exist without the other. People with no history of using credit don’t have a credit report or a credit score, and that makes it difficult for them to get approved for a loan and take on debt. However, if you have a history of managing debt well, lenders are more confident that you will make payments on time, and more willing to extend credit.
How to manage debt and credit responsibly
When possible, avoid using a credit card or taking out a debt without having a clear plan for repayment, unless you know you’ll be able to repay the amount you owe.
Payment history is one of the most important factors in calculating your credit score — in particular, in FICO scores, it’s 35% of your score. Pay all bills on time to avoid late fees and having late payments reported to the credit rating agencies.
If you owe money on your credit card and can’t afford to pay the balance in full, try to pay more than the minimum amount. Paying only the minimum each month could end up costing you quite a bit when interest is factored in, and it could take years to pay off the balance. (Our credit card payoff calculator can help you figure out how long it will take to pay off your balance and the interest you’ll be charged.)
If you can’t pay more than the minimum, that’s OK. Paying the minimum at least will help build a healthy credit history.
Whether a payday loan or title loan, be mindful of the fees that are tacked on to your debt. The annual percentage rate, or APR, can be a good measure of your cost of borrowing.
Your debt to credit ratio is a measure of how much of your available revolving credit (usually credit card limits) you’re currently using. You can calculate this ratio by dividing your total credit card balances by all of your revolving credit limits. Debt to credit ratio is a significant factor for calculating your credit score — the lower your ratio, the less risky you appear to creditors.
When you apply for new credit, the lender checks your credit, which results in a hard inquiry on your credit report. Hard inquiries can lower your credit score — especially if you apply for or open several new accounts within a short time frame. This signals to credit rating agencies that you might be having financial troubles.
One exception to this rule is if you’re shopping for a car or a mortgage. Credit rating agencies expect you to shop around for the best rate, so they ignore multiple hard inquiries for the same type of loan made within a 14 to 45-day period, depending on the scoring method.
You’re entitled to a free credit report from each of the three major credit reporting agencies every 12 months. Request these reports from AnnualCreditReport.com and review them for errors. Mistakes on your credit report can impact your credit score, whether you get approved for a loan and how much you’ll have to pay to borrow money.
If you find any errors on your credit report, follow the credit reporting agency’s instructions for disputing the information.
Debt vs. credit FAQ
Lenders and service providers use credit scores to make decisions about whether or not to offer you credit, how much credit they’re willing to extend to you, the interest rate they’ll charge and whether they’ll require a down payment or deposit. Having a good credit score makes it easier to do things like buy a home or a car, rent an apartment, get approved for a cellphone and set up utilities without a deposit.
Your credit score is essentially a measure of how well you manage debt. If you make debt payments on time, keep your debt balances low and use a variety of kinds of debt responsibly, you’ll have a healthy credit score.
“Good debt” is used to pay for something that has long-term value, increases your net worth and/or helps you generate income. For example, you might need a mortgage to buy a home, and real estate tends to have long-term value. You might get a loan to start or expand a business, which may increase your net worth if the business is successful. You might take out student loans to get a college degree, which can improve your earning power over time.
“Bad debt” is used to pay for things that have no lasting value. Credit cards are usually considered bad debt, as people may use them to buy things like clothing, electronics, vacations and expensive meals.
Debt tends to carry a negative connotation since it involves owing money. But when used wisely, credit can be a convenient way to pay for many things you otherwise might not be able to afford — after all, few people can afford to pay cash for a home or car.
Before taking on new debt, think through your current finances and your ability to repay the debt in the future. Remember: the more debt you take on, the less available credit and cash you’ll have going forward.