Understanding how debt impacts your credit will help you pay off loans quickly and efficiently. This guide aims to help borrowers understand the different types of debt and the nuances associated with them.
What Is Debt?
Debt is something (money, credit, assets) borrowed by one party from another. Borrowers use debt to make purchases that they could not otherwise afford. Usually, the borrower has a repayment window that can range from weeks to years, depending on the type of debt.
What Are the Four Main Types of Debt?
Beyond good or bad, we can break down debt into four main categories:
- Secured debt refers to debt backed by collateral like a car or house.
- Unsecured debt considers the borrower’s income and credit profile as the main factors for receiving a loan. There is no collateral involved.
- Revolving debt refers to a line of credit like a credit card.
- A mortgage is a secured debt used to purchase real estate.
Secured loans are less risky for lenders because they can repossess collateral (usually a house, car, or property), sell it and recover their losses. This is why applicants should receive lower interest rates and financing terms when getting a secured loan.
Some types of secured debt include:
- Auto Loan
- Secured credit card
- CD Loans
- Any loan with collateral
Unsecured debt is not backed by collateral. Lenders will have difficulty recovering their assets if borrowers don’t pay back their loans. Unsecured debt carries higher interest rates and stricter loan terms than secured debt.
Unsecured debt may include:
- Student loans
- Personal loans
- Medical bills
- Utility bills
- Payday loans
Revolving debt refers to credit accounts that carry over balances from one month to the next. Borrowers can draw their credit lines to a certain limit without paying off the total amount.
Some examples of revolving debt include:
- Credit cards
- Lines of credit
- Home equity lines of credit
Mortgages and Installment Debt
Installment debt refers to installment loans or installment credit. These are close-ended credit accounts borrowers pay back in regularly scheduled payments, known as installments.
The amount you pay is usually the same each time, though some borrowers may pay extra to rid themselves quickly of the debt. Installment debt typically carries interest that may be fixed or variable.
A mortgage is an installment loan borrowers use to purchase real estate. It is also a type of secured loan. Borrowers pay off the loan over time through principal and interest payments. Lenders hold a lien over the property or real estate until the loan is paid in full. Borrowers can save thousands in interest and fees by paying off their mortgage early.
Examples of installment loans include:
- Car loans
- Personal Loan
- Student Loan
What Types of Debt Are Good?
Each debt comes with its sets of pros and cons. Some debts can help further education and acquire a skill or be a valuable asset, like a home. Borrowers can pay off student loans and mortgages over an extended period, often decades. The interest is generally lower on these types of debts, making them easier to manage than high-interest credit cards.
What Types of Debt Are Bad?
The obvious answer is that high-interest debt is bad and should be avoided. Borrowers should avoid debt that doesn’t add long-term value to their life or net worth. Debt acquired for the sole purpose of consumption is bad debt. This may include revolving debt like credit cards that often carry high-interest rates and strict penalty rates. It also includes the payday loans predatory lenders use to target needy consumers. These kinds of debts almost always hinder more than help.
How Do I Get Out of Debt?
Some debt solutions require a good credit score, which is hard to maintain if you struggle with monthly minimum payments. Many borrowers find themselves in a debt cycle, taking on more debt to cover the existing debt or barely covering the minimum payments while interest climbs each month. While many can relate to this scenario, each consumer must devise a unique payoff plan that fits their lifestyle. Your debt payoff strategy comes down to your income, credit profile, and financial goals.
Some tips for paying off debt include:
- Pay more than the minimum
- Consider a payoff strategy like the debt snowball or debt avalanche method
- Make multiple monthly or bi-weekly payments
- Cut cable or subscriptions and put the money saved toward monthly payments
- Consider a debt management plan or debt consolidation loan
Debt Relief Options
Depending on the kind of debt, several types of debt relief programs offer financial relief.
- Debt management program: This program can help borrowers consolidate credit card accounts and reduce interest rates to manageable amounts. It provides financial counseling and budgeting that caters to a consumer’s unique circumstances.
- Debt consolidation loan: This is taking out one large, low interest loan and using it to pay off multiple smaller loans that have a high interest rate. It is a way to simplify your credit accounts. Reducing the monthly payments you make can ease financial stress and make it easier to remember when bills are due. You can also renegotiate financial terms and rates that better suit your current lifestyle and goals.
- Debt settlement: This method reduces the amount you owe creditors but has so many negative factors resulting from it that you need to research its value before choosing. Going through debt settlement may lessen your overall debt bill but will add late fees and interest payments to the balance and cost you fees to the debt settlement company. It will be a stain on your credit report for seven years.
- Bankruptcy: This is a reliable option for borrowers who determine they can’t repay their debts in five years and need a fresh start after exhausting all other alternatives. Bankruptcy will stay on your credit report for 7 to 10 years and make it hard to approach lenders, let alone acquire a loan. Credit counseling can help determine if you have too much debt and if this is your best way forward. Despite the downsides, bankruptcy can still wipe your slate clean of debts.
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