Debt refers to money that has been borrowed and needs to be repaid. Debt can come in several forms, but we’re talking about what financial debt means here.

To pay off a debt, the borrower generally needs to repay the amount that was borrowed plus a finance cost. That cost is usually interest. For example, if you borrow $100 at 10% interest, you’ll have to repay $110 at the end of one year to eliminate the debt.

Repayment might happen in one lump sum, or the debt might be paid off over time if the loan is amortized.

Who Borrows?

Individuals as well as organizations can go into debt. You’re probably familiar with the idea of a person borrows money, but companies, governments, and other entities borrow as well. For the most part, they get the same deal: taking on debt means you have to repay with interest. The amounts may be larger and things may be more complex, but the concept is the same.

What is the Point of Debt?

It costs money to use debt: interest costs and transaction fees can add up. It only makes sense to use debt when you’ll really come out ahead. For businesses, using debt means investing in projects or equipment that will ideally create larger profits in the future (assuming those profits will be enough to repay the debt).

Individuals might borrow to purchase a home or pay for education – both of which are difficult to fund with cash on hand. Of course, borrowing only makes sense if things work out (if the home gains value quickly enough, or if the education leads to an income that is high enough to justify the borrowing).

Risks of Using Debt

Borrowing, whether you’re an individual, a business, or a government, comes with risks.

Risk to your reputation: if you fail to repay as agreed, you may find it difficult (or too expensive) to borrow in the future. For individuals, your borrowing reputation lies in your credit; if you’ve been unable to repay a loan for any reason in the past, that loan may appear on your credit report, and lenders will be unwilling to work with you.

Businesses and governments also have credit ratings.

Financial risks: borrowing always costs money, and it can sometimes cost more than you expected. You might find that payments are difficult to keep up with, especially if the required payments rise or you’re forced to make a large balloon payment. If you pledged collateral, you may have to hand assets over to your lender, which can create another set of problems (imagine the set of problems that would arise if you suddenly had to give up your automobile or if you were evicted from your home). If the value of any seized assets is temporarily depressed (if the bank sells your home during a housing slump, for example), you’ll lock in a loss – and you’ll still owe money in some cases.

What is Good Debt?

To use debt wisely, make sure it really makes sense to borrow. Are you borrowing to pay for something that will save money or create financial security over the long run?

You might hear the term good debt used to describe borrowing that actually pays off over the long run, while bad debt refers to loans that add less value. The thing is, you probably won’t know whether or not a loan was a good idea until long after the fact, and sometimes traditional “good” debt turns into a toxic nightmare.

Typical examples of good debt include:

• Student loans
• Home loans

As you might imagine, those loans are only “good” if you borrow wisely: take only what you can afford to pay off, use the funds to invest in your future, and build equity. A little bit of good luck doesn’t hurt either.

And what is bad debt? It’s any loan that gets you into trouble or results in you paying a lot of interest for not much benefit. The best examples of bad debt include:

• Credit card debt
• Payday loans

Those types of loans come with very high financing costs. When you can’t afford to buy whatever it is you’re buying in the first place (that’s why you’re borrowing money), things quickly get worse when you also have to pay high interest costs. You can easily end up paying more than twice as much as you borrowed.

Some debt is tough to categorize – it could be good or bad. An auto loan might help you get the car you need to get to work and back, but it might also leave you with a burdensome monthly payment. Plus, your auto depreciates almost immediately after you drive off the lot (while a home, ideally, gains value over many years). Would you be better off paying $3,000 for a 10 year old car that’s more or less reliable?

Managing Debt

As you learn to handle debt, find out how loans work from start to finish. That way you’ll know how much it really costs to borrow and how much you’ll owe at any point in time. You can make better decisions about when and how to borrow, and you can evaluate alternatives to taking on debt.

If you’re going to borrow, keep your borrowing to a reasonable level. One way to do this is to use debt to income ratios: compare your monthly debt payments (for existing loans, as well as any new loans you’re considering) to your monthly income. The more of your monthly income you spend on debt repayment, the greater the risk you’re taking.

Finally, remember that you can repay debts early. Loans occasionally come with prepayment penalties, but most loans can be repaid at any time without any consequence. Just because you have a 30-year home loan doesn’t mean you need to use all 30 years – repaying early means you’ll save on interest costs. See How to Repay Debts Early.