A Guide to Debt
What is Debt?
Debt is money borrowed under the condition that it will be paid back at a later date, generally with interest.
Debt is NOT always bad!
Good debt increases your net worth or has future value. Examples of good debt: borrowing student loans to finance your education, a farmer taking a loan to buy another tractor (saving time and money, increasing productivity), or taking out a mortgage.
Bad debt does not increase your net worth or provide future value, and you don’t have the money to pay for it. Examples of bad debt: consumer products that lose value over time — new cars, timeshares, etc.
What is your Net Worth?
Your net worth can be calculated as (what you own — what you owe), or your assets minus your liabilities. A higher net worth is better because it means you have excess assets above and beyond what you owe. Calculate and compare your net worth here!
Types of Debt
Closed-End Credit
One-time loans for a designated purpose with a specified repayment schedule. If the individual fails to make a scheduled payment or “defaults”, the lender generally has some ownership rights as a means of incentivizing repayment (e.g., seizing a vehicle when a car payment is missed). Types of closed-end credit include:
Auto Loans
Student Loans
Mortgages
Open-End Credit
Lines of credit available to borrowers, generally with a maximum limit and higher interest rates. Open-end credit is not restricted to a specific use and represent a maximum limit rather than a fixed amount (i.e., additional money can be borrowed once the balance is repaid) — these are the key differences between closed-end and open-end credit. Types of open-end credit include:
Credit Cards
Debit Cards
Home Equity Lines of Credit (aka “HELOC”)
Creditworthiness
The Five C’s of Credit
Creditworthiness describes the likelihood that you will default on your credit obligation.
Lenders tend to use the following criteria to gauge borrowers’ creditworthiness:
Character — Credit history shows the borrower’s track record and reputation
Capacity — The borrower’s debt-to-income (DTI) shows their ability to repay the loan
Capital — Down payments, the borrower’s capital, decreases the likelihood of default
Collateral — The borrower can put up assets (collateral) that the lender can repossess in the event of default
Conditions — Loan conditions (interest rate, principal, etc.) influence the lender's desire to provide financing
FICO Credit Score
FICO (Fair Isaac Corp.) credit scores attempt to quantify your creditworthiness for lenders. FICO scores take into account five areas of creditworthiness: payment history, current level of indebtedness, types of credit used, length of credit history, and new credit accounts. FICO scores range from 300 to 850, with higher scores being better.
