What Are Credit and Debt?
Credit generally refers to your ability to borrow money or access goods and services with an agreement to pay later. Your credit history records how you have handled borrowing and payments over time.
Debt is money you have borrowed and still owe. Credit cards, loans and other borrowing arrangements can create debt that must be repaid according to the terms of the agreement.
Credit and debt are connected, but they are not the same thing. You can have access to credit without carrying a balance, and responsible use of credit can help establish a positive credit history.
Why Does Credit Matter?
Your credit history and scores can affect important financial decisions. Lenders may use credit information when deciding whether to approve applications and what interest rate or terms to offer.
Credit information can also matter when you apply for housing, certain insurance products, utilities and other services. The exact use of credit information depends on the company, product and applicable laws.
The Consumer Financial Protection Bureau explains that credit scores are used to estimate the likelihood that a borrower will repay money on time, and that different lenders can use different scoring models.
The Most Important Credit & Debt Topics
Credit and debt can seem complicated because several different numbers, reports and terms work together. These guides break the subject into practical questions.
Credit Scores vs. Credit Reports
A credit report and a credit score are related but different. A credit report is a record of information about your credit history. A credit score is a number generated using information from a credit report and a particular scoring model.
| Credit report | Credit score |
|---|---|
| Contains information about your credit history. | Summarizes credit risk using a scoring model. |
| Can contain accounts, payment history and reported balances. | Usually presented as a numerical score. |
| Reports are maintained by credit reporting companies. | Different scoring models can produce different scores. |
The CFPB notes that consumers can have multiple credit scores because lenders may use different scoring models, data sources and versions for different purposes.
What Can Affect Your Credit?
Credit scoring models differ, so there is no single formula used for every credit score. However, common information considered by scoring systems includes:
- Payment history
- Current debt and account balances
- How much available revolving credit you are using
- Length of credit history
- Recent applications for credit
- Types and number of credit accounts
- Certain negative information such as collections or bankruptcy
Payment history and how much of your available credit you use are particularly important areas to understand. The exact effect of any action depends on the scoring model and the information in your credit file.
Why Should You Check Your Credit Report?
Reviewing your credit report can help you identify inaccurate information and recognize accounts or activity you do not recognize.
The Federal Trade Commission explains that the nationwide credit reporting companies are required under federal law to provide consumers with free copies of their reports in accordance with the applicable requirements. Consumers can obtain their official reports through AnnualCreditReport.com.
When reviewing a report, look for incorrect personal information, accounts that are not yours, inaccurate payment information, duplicate accounts and other information that appears incomplete or incorrect.
Understanding Debt
Debt is not automatically harmful. Borrowing can help people finance purchases or expenses that would otherwise require significant cash upfront. The important questions are how much you owe, the interest rate, the required payment and whether the payment fits within your budget.
Different debts can have very different costs. A credit card balance, for example, may accrue interest differently from an installment loan.
Before taking on or keeping debt, consider:
- Total balance owed
- Annual percentage rate or other applicable interest rate
- Required monthly payment
- Remaining repayment period
- Fees and penalties
- Whether the debt is secured or unsecured
- How the payment fits into your monthly budget
How Credit Card Interest Fits In
Credit card interest can make a balance grow when you do not pay the full amount according to the card's terms. Many card issuers calculate interest using a daily method based on an average daily balance, although the exact terms depend on the card agreement.
A card may also have a grace period for purchases. When a grace period applies and you pay the required balance in full by the due date, you may avoid interest on eligible purchases. Cash advances and other transaction categories can have different rates or rules.
Understanding how interest is calculated is important before choosing a repayment strategy because a higher APR can make carrying a balance significantly more expensive.
Managing and Paying Off Debt
A debt payoff plan starts with knowing what you owe and how much each balance costs you.
A simple starting process is:
- List every debt and current balance.
- Record the interest rate for each account.
- Write down each minimum monthly payment.
- Review your monthly income and essential expenses.
- Choose a realistic additional amount for debt payments.
- Track balances as payments are made.
Two common approaches are the debt snowball, which generally focuses extra payments on the smallest balance first, and the debt avalanche, which generally focuses on the highest-interest debt first. Each approach organizes repayment differently.
What Is Debt-to-Income Ratio?
Debt-to-income ratio, or DTI, compares your monthly debt payments with your gross monthly income.
The basic formula is:
The CFPB notes that lenders can use DTI as one measure of a borrower's ability to manage monthly payments, and different lenders and loan products can have different DTI requirements.
Practical Credit Habits
There is no single action that guarantees a particular credit score. However, several habits can help you manage your credit responsibly:
- Pay bills on time.
- Monitor your credit reports for errors.
- Avoid applying for credit you do not need.
- Keep revolving balances manageable.
- Understand interest rates before carrying balances.
- Be cautious about closing old accounts without considering the consequences.
- Review your credit accounts regularly for unauthorized activity.
The CFPB specifically recommends paying bills on time, keeping balances low relative to available credit, applying only for credit you need and checking credit reports for errors.
Credit & Debt Resources on PaycheckMint
Use the individual guides below to explore specific credit and debt questions:
- What Is a Credit Score?
- How to Improve Your Credit Score
- How Credit Scores Work
- How to Build Credit
- How to Pay Off Debt
- How to Get Out of Credit Card Debt
- What Is a Credit Report?
- How Does Credit Card Interest Work?
- What Is Debt-to-Income Ratio?
- What Is Credit Utilization?