There are many different types of debt and they can generally be classified into four categories:
- Unsecured Debt
- Secured debt
- Revolving debt
- Non-revolving debt (Installment debt)
Debt terms can be confusing at times, but understanding the different types of debts out there can help you know exactly what you're getting yourself into. Learning about different types of loans will also help you make better financial decisions, and ensure that you're able to pay it off in a timely manner.
This comprehensive article will help you understand the various forms of debt, their benefits & drawbacks, and give you a good idea on how your debt can affect your financial standing. With this information, you'll be able make sure that you're kept financially secure.
Now, let's examine the four main categories into which debt is typically classified under.
Unsecured Debt
An unsecured debt is a type of loan that doesn't need you to put up any of your assets up as collateral. If you fail to make your minimum payments to an unsecured debt, your lender won't be able to take any of your possessions to cover their losses.
Some examples of unsecured debt include unsecured credit card debts, student loans, and medical debt.
Benefits
The perks of an unsecured debt is that you you won't have to put up any collateral to borrow the money you need. This means that you won't risk losing any of your assets if you're unable to pay back your debt.
Unsecured loans also generally get approved faster than secured debts since your lender doesn't need to assess the value of any collateral, making the approval process faster as compared to secured debts.
Risks
So what happens if you don't pay an unsecured debt? Normally, your creditor will try to get you to pay your debt by contacting you and asking for the money.
If they still can't get the money from you, the worst case scenario is that they might sue you. If they do so and win the lawsuit, they might be able to seize your stuff to get the money that you owe them.
Needless to say it's best to never get to this point in your debt, however, if you do get to this point, you may still be able to work things out by talking to your creditors to see if you can come up with a payment plan to pay off your debt.
Secured Debt
Secured loans is a type of debt that is backed by collateral such as a car or a house. This means that if you aren't able to pay back your loan payments on time, your lender has legal rights to seize the collateral you've put up in order to regain their losses. Some examples of secured debt are mortgages and car loans.
Benefits
Secured debts usually have lower interest rates as compared to unsecured debt since they have the right to seize your asset if you don't make your payments. You'll be able to save money in the long run by paying less interest on your loan with secured debts.
If you do go through unexpected financial hardship and aren't able to make payments on your secured debts any longer, you also know that you'll always be able to settle your debt using the asset that you've put up for collateral, protecting your other remaining assets.
Risks
The main risk of secured debt is that if you fail to make your payments, your lender can take away whatever asset you put up as collateral.
This means that if you don't make your car loan payments, debt collectors could get your car repossessed and sold in order for your creditor to retrieve their losses. Similarly if you don't pay off your mortgage, your lender can foreclose your home and take ownership of it – leaving you homeless.
Revolving Debt
Revolving debt is a type of credit that allows you to borrow money up to a certain limit, repay it, and continue to borrow money again. You'll be able to borrow and repay your debt indefinitely, as long as you don't exceed your given credit limit.
Credit card debt is a common example of revolving debt.
Benefits
With revolving credit you'll be able to borrow and repay funds as and when you need it as opposed to borrowing a huge amount all at once. This can be useful if you need to access funds on an ongoing basis but don't want to get into a huge amount of debt each time.
You also won't have to go through the process of applying for credit every time you want to borrow money which makes it pretty convenient.
Risks
The downside of revolving debt is that it normally comes with higher interest rates and late payment fees if you don't pay the money you borrowed in time. In many cases, these interest fees can grow to significant amounts which will make paying back your debt even more challenging.
With a constant line of credit, you also have a higher chance of falling into the habit of overspending and overusing your revolving credit. This can create poor financial habits that will affect your whole life if you aren't careful.
Also, your credit score will be negatively affected if you don't pay your debt in time.
When you have a poor credit score, it'll be harder for you to borrow money when you really need it. Your borrowing options will be limited to those with high interest rates, and even the types of insurance and jobs you're able to get could be limited if yo have a poor credit score.
Non-Revolving Debt (Installment Loan)
Non-revolving debt – also known as an Installment Loan – is a type of credit that must be repaid in fixed installments over a set period of time. Only when you have repaid the full amount of the installment loan is the debt considered paid off and the credit line closed.
Some examples of non-revolving debt are mortgages, car loans, and student loans.
Generally you need a good credit score and a steady income to qualify for non-revolving debt. Lenders may also look at things such as your debt-to-income ratio and work history when determining if you are eligible for this type of loan.
Benefits
The main benefit of non-revolving debt is that you'll be able to borrow a large sum of money all at once, which can be useful for big purchases like a house or a new car.
You'll also know exactly how much you need to pay each month and when the loan will be paid off, making it easier to budget and plan ahead for your monthly payments!
Additionally, non-revolving debt usually comes with lower interest rates than revolving debt, making it more affordable in the long run.
Risks
The main risk of non-revolving debt is that if you don't make your payments on time, it can have a negative effect on your credit score.
Also, if you fail to repay the loan, your lender could take legal action and file a lawsuit against you to redeem their losses. This could lead to repossession of property or garnishment of your wages to make good on the debt owed.
Common types of debt
Now that you know the main categories most debts fall under, let's go through some of the common types of debt out there.
Mortgage Debt
A mortgage is a type of loan that you can use to buy a house. Mortgage debt is classified as a secured debt as your lender will use the house as collateral to make sure you pay them back. A mortgage is also often the largest debt that individuals have in their lifetime.
When a borrower makes payments on their mortgage, they'll build equity in the home. When you have equity in a home, you'll be able to take out an equity loan. This is a type of loan that will allow you to borrow against the equity they you've built up in your home. These loans can be used for a variety of purposes including home renovations.
If you don't make your loan payments in time, your lender has the right to seize your property and sell it in order to make up for their losses. Your mortgage debt will consist of the money you borrowed + the extra money you have to pay for borrowing it.
Credit Card Debt
A credit card allows you to borrow money from a lender to make purchases or withdraw cash. When you using a credit card, you will be borrowing money from the credit card issuer and you'll need to pay back the money that you borrow with any interest charges that may apply.
If you don't pay off your credit card balance, your unpaid balance will accrue interest and you will continue to owe money to your credit card issuer.
Credit card debt is a huge issue in USA. According to the Federal Reserve – the total amount of credit card debt in the United States was over a trillion dollars in 2020, and the average credit card debt per household was over $8,600.
Auto Loan Debt
When you take out a loan to buy a car, it's called an auto loan debt.
Auto loans are relatively easy to pay off and have lower interest rates than other types of debt, such as credit cards or personal loans.
With auto loans, the car that you purchase will serve as collateral, making it a secured debt. This means that if you fail to make your auto loan payments on time, your lender has legal rights to repossess your vehicle – this also incentives borrowers to stay on top of their payments.
The average auto loan debt per household in USA is around $14,000.
Student Loan Debt
A student loan is a type of loan that you can take to pay for educational expenses such as tuition, college fees and university fees. They fall under the category of unsecured debts as there is no collateral involved.
Student loans include the amount you need for your educational cost plus interest rates. Typically, lenders will agree for student loans to be paid back from the time a student graduates from school.
In 2022, the average student loan debt a person has in USA is around $37, 000.
Guide: 3 Tips To Lower Your Student Loan Debt This Year
Medical Debt
Medical debt is debt that's incurred due to medical expenses such as hospital bills and medication costs. When you get medical treatment and you're unable to pay your full medical bill, you're left with medical debt.
Medical debt can be pretty challenging to manage since medical expenses often come unexpectedly and can't be predicted. They're also normally very expensive in the US.
Medical debt falls under unsecured, non-revolving debt as the debt won't incur any interest if you fail to pay it over time.
Corporate Debt
Small business owners may take on corporate debt – also known as business debt or corporate bonds – in order to pay for business expenses such as equipment, acquisition costs and hiring staff.
This type of debt can come from bank loans and other financing options that involves borrowing money from a lender and paying it back over time with interest.
The amount of debt that a small business has is a factor that investors and credit rating agencies consider when evaluating the financial health of a business.
Understanding The Different Types Of Debt
Knowing about the different types of debt out there is important for managing your finances and making better financial decisions. Whether you are thinking about taking out a new loan, considering debt consolidation, or trying to get out of debt altogether, it's important to understand the terms and conditions of each type of loan to make sure that you can afford to pay back what you have borrowed.
By taking the time to learn about the different types of debt and how they work, you will ensure that you fully understand the different loan terms and the financial commitment each loan entails before actually committing to them.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
