Financial knowledge at your fingertips
No matter your level of expertise, it’s important to understand the different types of debt you might consider throughout your life. Tackling debt, or even building your credit profile, can seem incredibly daunting, especially if you have multiple high-balance accounts looming over you. The good news is having a plan can help reduce your debt stresses and start chipping away at the amounts you owe.
Generally speaking, debt is something you owe to another individual or a business. For our purposes today, debt is money borrowed from, and therefore owed back to a lender or creditor. Individuals and businesses alike build debt by taking on lines of credit like mortgages, loans for business investments, or credit cards. One of the worst parts about debt is it typically accrues interest, so you’re often paying far more than you may have initially intended.
Borrowing money and taking on debt is not inherently bad or irresponsible. Most Americans have to rely on debt for one reason or another during their adult lives, and it can often be beneficial. Debt can help you get a car, a home, an education, and a host of other achievements. When considering a new debt, it’s important to evaluate the type of debt, purpose, the amount, the interest rate, and your ability to meet the monthly payment obligations.
Debts come in all shapes and sizes and can be an important resource for reaching your goals. Different debt types may come in handy for different endeavors, which is why it’s important to understand the different types of debt that exist, and which ones you’re using.
Secured debt is typically backed by assets, or collateral, so when you take on this kind of debt, you’ll have to put something of value on the table. Home and auto loans are always secured—should you stop meeting your payment obligations, the lender will be able to seize the collateral, the car, or home the loan is paying for.
On the other hand, unsecured debt is not backed by additional collateral. The lender supplies the loan solely with the expectation that it will be paid back, which is why this type of debt can have strict income and credit requirements and higher interest rates. Common unsecured debts include medical debt and most credit cards (some credit cards can be secured, so keep this in mind as you evaluate your options).
Revolving debt allows you to borrow money, make payments, and continue borrowing up to your credit limit. Credit cards are a great example of revolving debt—you spend what you need each month, make your payment, and continue borrowing the next month. Revolving debts will typically have a minimum payment each month, and a variable interest rate applies to the balance you carry.
With installment debt, a lender provides a large lump sum, which the borrower must pay back according to the terms of the agreement. Usually, this will include regular payments of equal amounts, using a fixed interest rate.
As we described above, not all debts are created equal. They each have their own requirements, terms, and impacts. While this is important to consider, remember that debt is not always a bad thing, and having multiple debts can even improve your credit score. Lenders like to see that you can responsibly manage more than one type of debt, so diversifying your debt is a great idea if you have the bandwidth to do so. Below we discuss common examples of consumer debt, so you can start thinking about how you might want to diversify your debt in the future.
As we mentioned previously, credit cards can either be secured or unsecured, although most are unsecured, unless otherwise specified. A typical, unsecured credit card loan is revolving. You can spend up to your credit limit each month, make at least the minimum payment (although you should aim to pay it in full each month), and continue spending the next month, again, up to your credit limit for that card, and so on. It’s important to consider interest rates, fees, and perks (like cashback, points, or other rewards) when considering which credit card to get. When it comes to credit cards, interest rates vary greatly, but they often fall between 10% and 25%. The interest rate associated with your credit card will be applied to the remaining balance, so you can avoid paying any interest at all if you pay your card off each month.
There are also secured credit cards, which require a cash deposit, which generally serves as the credit limit. Secured cards are typically offered to those with poor or no credit and can be a great resource for building credit. If you choose to close a secured card account, your deposit will be returned.
A credit card can be a great resource for beginning or improving your credit history, so long as you make sure you’re paying your bills off each month. On-time payments greatly impact your credit score, so developing this habit early will have a huge impact on generating good credit.
Auto loans are loans for the purpose of purchasing a car. These are a type of installment loan, so you’ll typically pay a set amount each month for the duration of the term. They’re also secured loans, so the car the loan is paying for is considered collateral against that loan, and can be seized for failure to pay. Interest rates and term lengths vary depending on the lender, down payment, and other factors, which makes it imperative to consider all your options when shopping for an auto loan.
A mortgage loan is a loan used to fund the purchase of a house, land, or other real estate. Like auto loans, mortgages are secured installment loans, so you’ll regularly pay a set amount, but if you stop paying for any reason, the lender can seize the house associated with the mortgage. Usually, mortgage interest rates range from 3% to 5%. Terms tend to be 10, 15, 20, or 30 years.
A home equity loan is an installment loan that provides the borrower a lump sum based on the value of their home. Home equity loans do NOT affect the terms of your mortgage. Home equity loans can be pretty flexible, providing you the funds for a variety of uses, like a home remodeling project, a wedding, medical expenses, etc. Since they are secured by your home, these loans often have low interest rates.
Personal loans can be really helpful when you need a large sum with flexibility to repay it over time. This type of unsecured installment loan will often carry a term from a few months, up to 10 years. Loans with a longer term often have lower interest rates, however, interest certainly adds up over time, so it’s still important to pay these debts down as soon as you can. Individuals might opt for a personal loan to pay down other debts, finance a big purchase like a home or car, or finance other high-value events, like starting a business or planning a wedding. However, some lenders may have restrictions on what a personal loan can be used for, so be sure to read all the terms before choosing a provider.
Keep in mind that some personal loans can be secured, requiring a savings account or other form of collateral.
Student loans are a type of debt used to cover education expenses like tuition, books, room and board, etc. They are, naturally, unsecured. The lender can’t take your education back if you fail to meet your payment obligations. These are still installment loans though, with a fixed amount due over the term of the loan. Interest rates vary depending on the lender, but loans provided through the Department of Education will have a fixed rate set by the federal government. Considering student loans tend to be one of the first forms of credit young people take on, it’s crucial to make sure you make payments on time to build your credit.
Medical debts are unique because they don’t often come with a payment structure. Of course, they aren’t a type of secured loan, and they typically don’t require payment in regular installments. Often, you can work with your provider’s billing department to create a payment plan.
The best way to accomplish any goal, especially financial, is with a well-thought-out plan. Below, we outline tips and strategies for creating an effective repayment plan and managing your debt.
You should start planning to tackle your debt by taking inventory of what debts you currently owe. It can be helpful to write them down, along with their balances and interest rates, to get a good idea of your debt situation and start planning. It’s important to keep interest rates in mind as you prioritize your debts, so you know which ones will impact you the most. You should aim to prioritize debts with higher interest rates, but also consider the consequences of nonpayment. For example, it’s probably good to prioritize your car and mortgage payments because those collateral items are crucial to your daily life.
Creating a budget can be a great way to clearly visualize and analyze your spending habits throughout the month. A budget, essentially, provides a snapshot of your income and expenses during a given month, with a plan for spending and saving. Keeping your current debts in mind, you can use a budget to plan for monthly payments and adjust your other spending to ensure that you meet your obligations. There are a number of budgeting methods out there, so try to find one that works well with your family’s needs and goals.
Looking at the debt totals you outlined earlier, it might be hard to imagine getting it all paid off. To help you breathe a little easier, it’s better to focus on analyzing your budget and determining how much you can commit to paying each month. Follow the SMART framework of goal setting, making your goals specific, measurable, achievable, realistic, and time-set. This outline will help keep you on track without biting off more than you can chew. When setting your goals, remember, you should always try to pay at least the minimum payment on your debts to avoid late fees and going to collections.
Using the Avalanche method, you would make the minimum payments on all your debts, then put any extra funds towards paying off debts with the highest interest rates. This method can help you quickly eliminate your most expensive debt, and then move on to tackling the next most expensive, and so on. This strategy can be great for individuals with high interest rates, allowing you to quickly manage your debt and avoid paying absurd amounts in interest.
The Snowball method is quite similar, although it aims to eliminate the debt with the lowest balance. So, you would still pay your minimums on all debts each month, but then allocate any remaining funds to paying off your debt with the smallest balance. The Snowball method can be a helpful way to slowly start tackling your debts and achieving small wins quickly to maintain your motivation.
Now that you have most of your debt repayment plan together, you can look at the full picture and plan for spending. You may need to curb some unnecessary spending to meet your payment goals. Think about ways you might be able to cut back or save. Turn lights off when you leave a room, opt for store brand products rather than name brand, put on a sweater instead of turning up the heat, etc.
While you’re tackling your debt, you should still consider saving where you can. It’s important to have an emergency fund tucked away, so you’re covered when unexpected expenses arise. If you run into an expensive emergency without any savings, you might get derailed, having to pause your debt repayment to afford whatever issue arose, and then you’d be stuck with interest and late fees on top of everything else. It doesn’t have to be much, and every bit adds up, especially if you keep your funds in an interest-earning savings account.
Debt isn’t always a bad thing, and it can actually be great for your credit history. When considering new debts, it’s important to compare debt type, terms, interest rates, fees, and perks to make an informed decision. You should always keep your debt in check, and no matter how much debt you choose to take on, you should always have a plan for repayment.
