5 Types Of Debt: Defined And Explained
Andrew Dehan6-Minute Read
September 23, 2021
In this day and age, every major life event – going to college, buying a car, owning a house – is associated with debt. According to Business Insider, the average American has $52,940 worth of debt across a combination of mortgage loans, auto loans, student loans, credit card debt and other debts.
But what’s the difference between these various types of debt? And why are some forms of debt considered better than others? In this article, we’ll take a closer look at the categories of personal debt, and how to manage them.
What Are The Different Types Of Debt?
Personal debt, also known as consumer debt, is defined as money owed as a result of purchasing goods or services for individual consumption. Everything from student loan and credit card debt to mortgages and personal loans are considered types of private debt.
With that in mind, let’s explore the categories of personal debt: secured, unsecured, revolving, non-revolving and mortgages.
A secured debt is any debt that requires you to put down an asset as collateral. Similar to a secured loan, this type of debt necessitates that you pledge a personal asset, such as a car or boat, in order to secure the loan. If you don’t repay the debt, your lender could seize the asset.
To take on a secured debt, you’ll have to pass a credit check, which is based on your creditworthiness. Since this type of loan is secured against collateral, it usually comes with a lower interest rate than unsecured loans.
One of the most common examples of secured debt is the auto loan. Here’s how it works: You take out a $10,000 auto loan from a bank, online lender or credit union. The loan is secured against the car, which acts as collateral. If you make on-time payments for the life of the loan, you’re good to go. But if you stop making payments, your lender has the right to repossess your car.
In contrast to secured debt, unsecured debt is any loan that doesn’t require collateral. Unsecured loans are approved based on your creditworthiness, as well as your income level and amount of outstanding debt.
Since this type of loan is not secured against collateral, unsecured debts usually have higher interest rates. In some cases, they may also have stricter qualification requirements or require a co-signer.
Some examples of unsecured debt include credit cards, medical bills, student loans and personal loans. It’s almost too easy to accumulate unsecured debt due to the lack of collateral requirements, so it’s important to keep track of your monthly payments to avoid falling behind.
Revolving debt is an open line of credit from a lender that allows consumers to borrow a predetermined amount of money on a recurring basis. This type of debt can be secured or unsecured, depending on the type of credit.
Common examples of revolving debt are credit cards, lines of credit and store cards. Revolving debt allows you to spend up to the loan limit, make monthly payments on the debt and then continue spending. Basically, you can “revolve” your line of credit as you pay back what you borrowed.
While revolving lines of credit are easy to use for consumer spending, you can fall into financial trouble if you spend more than you’re able to repay. Plus, if you pay anything less than the full debt, you’ll be charged interest on the remaining balance.
Non-revolving debt, also known as installment debt, is when you borrow a specific amount of money and repay it on a preset schedule. Every month, you’ll make equal payments, plus interest, until you pay down the loan.
Installment debt is a popular way to finance expensive purchases, such as cars, houses and major appliances. This type of debt is less risky than other types of loans that don’t have installment payments, and allows you to plan ahead for your set monthly payments.
This type of debt is well-known to most homeowners, thanks to the fact that mortgage balances are the largest component of household debt in the U.S. In fact, this type of debt has the largest consumer debt balance, beating out student and auto loans.
Mortgages are secured loans that are used to buy property, with the house itself used as collateral. In most cases, mortgages are provided with 15- or 30-year terms to make the monthly payments more affordable for homeowners.
On the plus side, mortgages typically feature lower interest rates than other types of loans, due to the long repayment period. Before securing your mortgage, shop around to multiple lenders to ensure that you’re receiving the most favorable interest rate and loan terms possible.
Good Debt Vs. Bad Debt: What’s The Difference?
It would be easy to argue that no debt is good debt, but in reality, taking out loans is the only way that many people can afford expensive items, such as a home. With this in mind, we can examine the difference between debt that helps you invest in your future versus unnecessary debt.
Good debt is considered money borrowed to improve you or your family’s life in a positive manner. If your purpose for taking out a loan is to build your net worth or generate more income, that’s considered positive debt. Some examples include taking out a student loan for higher education, taking out a mortgage to buy a home or borrowing funds to start a business.
On the other hand, bad debt is defined as money borrowed to buy a depreciating or unnecessary asset. Some examples of bad debt include taking out a loan to pay for vacation, using an auto loan for a too-expensive car or borrowing funds to pay for unnecessary clothes.
4 Tips To Get Out Of Debt Fast
So, what happens if you fall into one of the various types of debt? The first step to managing your debt is evaluating the full scope of the problem. Once you know how much you owe, follow these guidelines to help pay off debts fast.
1. Create (And Stick To) A Budget
Creating and sticking to a budget is a great step toward becoming debt-free. Start by adding up your monthly expenses, including bills, as well as your monthly income. When writing down your expenses, carefully evaluate what you spend money on and whether there’s room to cut back on nonessentials.
After accounting for your monthly expenses, calculate how much money is left over. That amount should now be allocated for paying down your debt. It can feel difficult to cut down on fun purchases, such as vacations and shopping, but it will benefit your financial future.
2. Try The Debt Snowball Method
The debt snowball method is a tried-and-true way to work your way out of debt. Here’s how it works: Continue making the minimum payments on everything but your smallest debt. For that one, put as much of your monthly budget toward it as possible. That way, you’ll be able to pay it off quickly, and then move on to applying the same method to the next smallest debt.
One of the main benefits of this debt reduction method is that as you pay off your smaller debts, you’ll free up more funds to put toward the larger debts. Plus, you’ll feel motivated to continue closing out loans until you’re debt-free.
However, the downside of the debt snowball method is that you may end up paying more interest if you choose to pay down smaller debts with lower interest rates before larger debts with higher interest rates. Keep this in mind as you plan out your debt reduction strategy.
3. Consider Consolidating Your Debt
If you’re having trouble juggling your monthly debt payments, debt consolidation could be your answer. Debt consolidation is the process of merging multiple loan payments into one monthly payment. That way, you’ll owe one lender instead of several, plus you can find a lower interest rate to help you save money while you pay down your debt.
There are several methods for consolidating debt, including credit card debt consolidation, a debt consolidation loan, a home equity consolidation and a 401(k) loan consolidation. Every option has its advantages and disadvantages, but you should consider your income level, amount of debt and credit score when choosing the method that’s best for you.
4. Seek Debt Counseling
There’s no shame in asking for help managing your debt. If you’re struggling to find a debt reduction plan that works for you, consider finding a local credit and debt counseling service to help you get on track.
If possible, try to avoid debt counseling services that will add an additional cost to your monthly budget. Instead, seek out free services from nonprofit or community organizations in your area.
The Bottom Line: Not All Debts Are Created Equal
If you plan to purchase your own car or home, you’ll most likely have to go into debt to do it. That’s why it’s important to understand the distinction between good debt and bad debt, as well as the various types of debt.
In order to take steps to manage your current debts, you’ll have to address the expenses and financial habits that put you in debt. To take control of your financial future, check your credit score for free and monitor your efforts over time.
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