Is debt always bad?

Not all debt is the same. Before you borrow money, it's crucial to understand the different types of credit and how to manage them. We talk you through it.

Debt can feel negative. But used wisely, it may help you buy things you couldn’t afford outright.

Few people could buy a house or flat with cash, so a mortgage is how most people generally buy a property. As long as you don’t take on a bigger mortgage than you can afford and you have a plan to pay it off, a mortgage may be a sensible way to borrow.

Other longer term products include car loans and home-improvement loans. Repayment terms generally vary between one and five years. These products can help you buy something now that would otherwise take years of saving.

Short-term borrowing

Short-term borrowing can be a great way for first-time borrowers to get disciplined about paying off credit.

If you spend modest amounts on a credit card, and pay the balance off in full each month, you’re demonstrating to lenders that you can handle credit responsibly.

Other ways to show you can manage your money include having a mobile phone contract and paying the monthly amount on time, or responsibly using your overdraft when needed and repaying it.

Put simply, small amounts of responsible borrowing count in your favour. That's because it helps build your financial track record – also known as a credit rating or credit score. Just be sure you don't miss any payments, and your score should improve over time.

Long-term borrowing

If you need to make a big purchase, you could consider applying for a mortgage or a personal loan. These have set repayment rules, and you need to make your regular monthly payments.

Building a good credit rating

A credit history is a track record of all the credit you have applied for. It includes records of your overdrafts, credit cards, personal loans, mortgage and most other borrowing. You get a score based on a number of factors, including how much you are currently borrowing and how well you have paid back money you previously borrowed. You can track your score by registering with a credit reference agency.

Lenders look at your credit rating when deciding whether to offer you loans and mortgages. If you've never borrowed money, you may find your credit score is lower than that of someone who borrows regularly but pays it off on time.

Small, short-term lending could help build your credit score. For example, buying your phone on a 24-month repayment contract or an item of furniture on store credit.

How to borrow well

Learning how to budget will help you decide how much you can afford to borrow and pay back. You can keep track of your outgoings on an app or spreadsheet to help you see where your money goes each month.

Budgeting can also help free up money that you could put in a savings account.

When you're thinking about taking out credit, work out how much you will pay back in total by adding up the cost of each monthly payment plus any arrangement fees or initial lump sums.

Don’t simply take the first credit offer you see – shop around for the best deal by using comparison websites.

Avoid missing repayment dates by setting up reminders, paying by Direct Debit or using an app to track your monthly instalments.

Planned debt is better than unplanned debt

Here's why this is generally the case:

• Planned debt is cheaper. If you have an arranged overdraft, stay within the credit limit of your credit card or arrange a personal loan, you will usually pay less than with an unarranged overdraft
• Unplanned debt can carry extra fees. If you go over your credit card limit, use an unarranged overdraft or miss a loan payment, you’ll probably face penalty charges or extra interest
• Missed payments may hurt your credit rating. Failing to pay your loan instalment, failing to make the minimum repayments on a credit card or missing a mortgage payment can seriously hurt your credit score and may mean other lenders won’t lend to you in the future

To summarise, if you have short-term borrowing needs, a credit card could provide a low cost solution, especially if you can pay it back in full by the payment due date. Alternatively, an overdraft can help with cash flow management, but it shouldn't be used as a regular borrowing solution because the charges can be high. A longer term project could be paid for by a mortgage or personal loan. And remember – planned debt is generally much cheaper than using a payday lender.

Recommended reading

• Let's talk about debt
• 10 ways to stop (over) spending
• How to separate joint debt after a divorce

This article is for information only and does not constitute financial advice. We encourage you to work with a professional adviser to consider your individual circumstances.