What is debt?
Debt is money you have borrowed from a person or a business. When you owe someone money, you have a liability. When you owe money, you have to pay it back, sometimes in scheduled payments. You will often use money from your future income to make those payments.
While borrowing money may give you access to something today, you may have monthly payments for months or years going forward. This obligation can decrease your options in the future.
Debt is different from credit. Credit is the ability to borrow money. Debt results from using credit. You can have credit without having debt. For example, you may have a credit card on which you don’t currently owe money because you paid the balance off and haven’t made new purchases with it.
Good debt, bad debt?
Sometimes people label debt as “good” debt or “bad” debt. Some debt can help you reach your goals or build assets for the future. People will often say that borrowing for your education, for a reliable car, to start a business, or to buy a home can be a good use of debt.
But it’s not always that simple. For example, borrowing to further your education may be a good use of debt because earning a certification or a degree may lead to a better paying job and more job security. But if you take on the debt and don’t earn the certificate or degree, this student debt has set you back instead of helping you reach your goals.
Taking out a loan to get a reliable car to get to and from your job can help you pay your bills and save for goals. However, if you borrow 100% of the car’s value, you may end up owing more than the car is worth. Or if you buy a more expensive car than you need, you’ll have less money for other bills each month. While it may get you to work, it might keep you from getting to your financial goals.
Borrowing money to start a business may help create income for yourself and others. If the business fails, however, you may end up owing money and not having any income you can use to make the payments.
Finally, taking out a loan to buy a home of your own may be a way to reach your personal goals. But if you are unable to keep up with the payments or you end up owing more than your home is worth, that debt may set you back for a long time.
That’s why even debt that many people consider “good” should be approached with caution.
Some people consider loans such as credit card debt, short-term loans, payday and pawn loans “bad” debt. This is because they may carry high fees and interest, and when they have been used for things you consume (like meals out, gifts, or a vacation) they don’t help build assets. But, these sources of debt can help cover a gap in your cash flow if you have a way to repay them.
So, there is no one type of debt that is “good” or “bad.” That’s why it’s important to first understand your goal or your need. Then you can shop for the credit you need, especially for large purchases like a car or a home, before you make your final decision on your purchase.
Secured and unsecured debt
Another way to understand debt is whether it is secured or unsecured. Secured debt is debt that has an asset attached to it. When debt is secured, a lender can collect that asset if you do not pay. Here are examples of secured debt:
- A home loan. The debt is secured by the home you are buying. If you do not pay your loan, the lender can foreclose on your home, sell it, and use the money from the sale to cover some or all of your loan.
- An auto loan. The debt is secured with your car. If you do not pay your loan, the lender can repossess (repo) your car and sell it to cover some or all of the loan.
- A pawn loan. The debt is secured with the item you have pawned. If you do not make payment when it is due, the pawned item is eventually sold.
- A secured credit card. The debt is secured by funds you deposit at a bank or credit union. Your credit limit will generally equal your deposit. For example, if you deposit $300, your credit limit will be $300.
Unsecured debt does not have an asset attached to it. Here are examples of unsecured debt:
- Credit card debt from an unsecured card
- Department store charge card debt
- Signature loans
- Medical debt
- Student loan debt
If these loans are not paid as agreed, since there is no asset to repossess, they often go directly to collections.
How much debt is too much?
One way to know if you have too much debt is based on how much stress your debt causes you. If you are worried about your debt, you may have too much.
A more objective way to measure debt is the debt-to-income ratio. The debt-to-income ratio compares the amount of money you pay out each month for debt payments to your income before taxes and other deductions. The resulting number, a percentage, shows you how much of your income is dedicated to debt— your debt load.
The debt-to-income ratio is a simple calculation: Total of your monthly debt payments ÷ Monthly gross income (income before taxes). The higher the percentage, the less financially secure you may be, because you have less left over to cover everything else.
Everything else is all of the other needs, wants, and obligations you pay each month that is not debt. For example, if you have a debt-to-income ratio of 36%, you have 64 cents out of every dollar you earn to pay for everything else, including all of your living expenses and taxes. This include:
- Healthcare (that has not turned into debt)
- Child support and other court-ordered obligations