Types of Debt: Understanding What You Owe

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Most people fail to realize that there are many different types of debt. Although we know the general names of the things we owe money on, such as a mortgage, they fall within categories. Knowing what type of debt you have under your name can help you better understand how to maximize your payments.

What Are the Most Common Types of Debt?

The first thing to consider when looking at your debt is the general categories your liabilities belong to. There are four primary forms of debt that individuals and families experience throughout their lifetime. Known as secured debt and unsecured debt, they have significant differences in how they work and how you pay them off.

Secured Debt

Secured debt can sound scary at first, but it is also widespread throughout the United States. With this type of debt, you are essentially “securing” the loan to something you own, typically expensive assets. For example, if you opt for a secured loan, you might offer your home as collateral to protect the borrowed funds.

Most banks require individuals to choose secured debt when borrowing large sums of money. If the individual defaults (misses) their payments, the bank has collateral to leverage against the borrower. In most cases, the collateral, being their home, will force loan holders to pay their debts back.

If a borrower cannot pay their debt, the banks will seize their property, sell it, and take the profits from the sale. Using this method, they can recoup the costs of the loan they had initially provided. At this point, you might be wondering who would voluntarily sign up for a secured loan?

The most significant benefit of this type of loan is that they have significantly lower interest rates. Considering interest prevents you from paying off the principal balance as quickly, they can be preferred. Often, individuals who know they can meet their monthly loan payments can benefit from lower interest rates.

Different Types of Secured Debt

Learning the different types of secured debt opened my eyes to the number of ways families can borrow money. Some of the most common examples of this type of debt include:

Mortgages

By far, the most common type of secured debt is mortgages because of how they’re structured. When you get a mortgage, you will make monthly payments to pay down the amount owing on your home. However, if you default on your mortgage, you could face significant consequences, such as property seizure.

Car Loans

Another increasingly common type of secured debt is car loans. When you enter a loan agreement for a new or used vehicle, you are agreeing to pay monthly installments. With these installments, you will be paying off the cost of the vehicle, similar to mortgages.

Another factor that makes a car loan similar to a mortgage is what happens if you default on your payments. Individuals who don’t pay their car loan are subject to repossession, in which the bank takes your vehicle. They will then auction the vehicle off and use the money received to pay down your loan.

A significant difference is that you could still be on the hook for payments if you default on a car loan. If the bank receives less money than the loan’s value when the vehicle is sold, you’ll pay the remaining amount.

Unsecured Debt

On the other side of the spectrum, you will find unsecured debts, which are the most common. Unsecured debts can include anything from personal loans to gym memberships that require contracts. In fact, it is more than likely you’ve entered an unsecured debt agreement several times throughout your lifetime.

Compared to secured debt, unsecured debt does not have any leverage. For example, the banks or lenders won’t seize your property if you default on your payments. As there is no leverage, you can bet that the interest rates with these loans are traditionally higher.

It is important to note that unsecured loans might be the only option for many individuals nationwide. As more individuals delve into the rental market, they have few assets to use as collateral. This situation leads them to borrow more significant sums of money with higher interest rates, making the debt harder to pay off.

Fortunately, there are plenty of lenders who work with unsecured debt and try to make repayment simpler. Typically, they will offer low, fixed interest rates that extend over a more extended period. This agreement can be mutually beneficial, as you pay less per month, and the lender receives the same amount over time.

Different Types of Unsecured Debt

Unsecured debt is more common because it is easier for many individuals and families to receive. Some of the most common types of unsecured debt include:

● Credit cards

● Medical bills

● Personal loans

● Student loans

● Consumer Debt

Knowing the types of consumer debt can help you prepare for managing your personal finances. This particular type of debt refers to balances that you own relating to household expenses or personal consumption. For example, payday loans, mortgages, student loans, and credit cards can all be classified as consumer debt.

Most economists rate this type of debt as one of the worst because of their interest rates. Due to their higher interest rates, they can be challenging to pay off, forcing families into dire financial situations. Payday loans, for example, are known to have incredibly high interest rates on minimal borrowed amounts.

What Is Consumer Debt?

There are two main types of consumer debt, known as revolving debt and nonrevolving debt, as we get into below. It is important to note the pros and cons of consumer debt before signing up for it.

Advantages of Consumer Debt

Let’s take a look at the benefits experienced from different types of consumer debt.

Improving the Economy

There is no doubt that when people have access to more money, they are inclined to spend more. With consumer debt, individuals can fuel the economy, ensuring consumption is smoothed. Without spending, the balance of supply and demand is off-kilter, leading to detrimental economic effects.

Useful Purposes

There are many instances where consumer debt directly benefits the borrower, as in student loans. By borrowing money in your early life, such as when you start school, you’re putting money towards your future. The money you have been lent provides you with the opportunity to attend a college or university and acquire a higher income.

This same theory applies to making small, immediate purchases, such as buying household appliances. By taking on consumer debt, homeowners can ensure they have adequate access to cooking appliances and more.

Disadvantages of Consumer Debt

There are a couple of key issues to consider apart from reaping immediate spending benefits and improving the economy. Consumer debt can also be hazardous when mishandled.

High Interest Rates

There is a reason why economists don’t like consumer debt; it comes with higher interest rates. The higher the interest on a loan, the more challenging it can be to pay off, especially with predatory loans.

Payday loans, for example, allow individuals to borrow money with the agreement that they will pay the sum back on their payday. However, regardless of the amount you’re borrowing, payday loans will have exceptionally high interest rates. This issue can make it significantly more challenging to pay back what you owed in a reasonable timeframe.

Lack of Appreciation

Another significant issue with taking on consumer debt is that many of the things you buy do not increase in value. Instead, they are often immediate wants or needs rather than a future asset that will increase in value. This is why consumer debt is not seen as a profitable or beneficial expense.

The Types of Consumer Debt

With an idea of the benefits and disadvantages of consumer debt, let me explain the two primary types: revolving and non revolving.

Revolving Debt Revolving debt is much like its name. It is a type of debt that you borrow and pay off to borrow again. Credit cards are typically considered as revolving debt, especially if you use yours regularly.

When you use your credit card and then pay the balance down, you still have credit available to use again. This theory also applies to store cards and even tabs that you have open at local businesses.

Similar to other types of debt, revolving debt has interest rates applied to the balanced borrowed. For example, if you spend $100 on your credit card with an 18% interest rate, your payment will be $118. Depending on the type of revolving debt you have, interest rates can often be high, especially with credit cards. This is why it is vital to ensure you manage your money effectively.

These forms of debt can be scary for people accustomed to spending a lot of money. Typically, the minimum payments required to not default on revolving debt are very low compared to your balance. It can make it feel like you’re making a dent in what you owe every month.

Non Revolving Debt

Many types of secured debt could also be classified as non revolving, such as mortgages and car loans. As the complete opposite of revolving debt, this type of borrowing isn’t designed to be used more than once. Essentially, you will borrow money with the sole purpose of purchasing a product and paying for it over time.

With nonrevolving debt, you will have a monthly minimum payment to be made. This payment is calculated over a specific period (six months, five years, or longer) by creating monthly payments. You will also have interest applied to the remaining balance, which makes your monthly payments fluctuate.

Interest rates can be a significant issue with nonrevolving debt. Let’s use a mortgage as an example. If you have a 30-year mortgage for $250,000 with 3.8% interest, your total mortgage is actually $420,000. You’ll have approximately $170,000 in interest that will be paid over 30 years, which is more than half the value of your home.

Another critical thing to consider with nonrevolving debt is that it typically takes longer to pay off than revolving. Also, they are often associated with more considerable borrowed sums, traditionally in the tens of thousands.

Final Thoughts

Managing your debts is of the utmost importance so that you can experience the positive effects they have on your life. Otherwise, you could find yourself drowning in a pool of owed funds with interest rates tacked on top.

There are many different types of debt that everyday households encounter to maintain a comfortable lifestyle. If you find the time to know what you are getting yourself into, you would be better able to manage your payments and pay your debts off on time.

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