July 29, 2021 |8 min read
Understanding how debts are classified—and how the classifications work—can help with financial decisions
July 29, 2021 |8 min read
In the simplest terms, a person takes on debt when they borrow money and agree to repay it. Common examples are student loans, mortgages and credit card purchases.
But did you know those loans are actually considered different types of debt? Debt often falls into four categories: secured, unsecured, revolving and installment. And, as you’ll see, categories often overlap. Keep reading to learn more about how debt is classified.
1. Secured Debt
To understand secured debt, it might help to put yourself in the shoes of a lender. Every time a person asks to borrow, a lender has to consider whether that debt will be repaid. Secured debt allows creditors to reduce their risk. That’s because secured debt is backed by an asset, also known as collateral. In other words, the collateral “secures” the loan.
Collateral can be in the form of cash or property. And it can be taken if borrowers fail to make payments on time. Keep in mind, failing to repay a secured debt can have other consequences. For example, missed payments could be reported to credit bureaus. And an unpaid debt could eventually be sent to collections.
A secured credit card, for example, requires a cash deposit before it can be used for purchases. Think of it as a security deposit you put down to rent an apartment. Mortgages and auto loans also represent secured debt. With those, the purchased property— such as the house or the car—typically acts as collateral.
There’s a bright side to collateral though: Lower risk to the lender might mean more favorable financing terms and rates for the borrower. And some lenders may be less strict about qualifying credit scores too.
2. Unsecured Debt
There’s no need for collateral when a debt is unsecured. Think student loans, traditional credit cards or personal loans. Without collateral, your credit will likely be a bigger factor in determining whether you qualify for unsecured debt—though there are exceptions when it comes to some types of student loans.
Lenders examine your credit by using credit reports. That’s true of most debts. But lending criteria may differ. Creditors generally take into account things like your payment history and outstanding debt. Such factors are also used to calculate credit scores—another tool lenders might use.
Generally, the higher your credit score, the better your options. On an unsecured credit card, for example, a higher score could help you qualify for higher credit limits or lower interest rates. Some cards may offer perks such as cash back, rewards miles or points. Keep in mind, a higher score won’t guarantee you’ll be approved for unsecured cards or other loans.
And just because a debt is “unsecured,” it doesn’t mean missed payments are OK. Falling behind could still affect your credit and eventually lead to collections or a lawsuit.
3. Revolving Debt
If you’ve got a secured credit card or an unsecured card, you may already be familiar with revolving debt. A revolving credit account is open-ended, meaning you can charge and pay down your debt over and over—as long as the account stays in good standing. Personal lines of credit and home equity lines of credit count as revolving credit.
If you qualify for a revolving credit line, your lender will set a credit limit, which is the maximum amount you can charge to the account. Your available credit then fluctuates each month, depending on how much you use it. Minimum payment amounts may change every month too. And any unpaid balance carries over to the next billing cycle with interest tacked on. The best way to avoid interest charges? Pay in full each time you get a bill.
4. Installment Debt
Installment debt differs from revolving debt in a number of ways. Unlike revolving credit, this type of debt is closed-ended. That means it’s repaid over a fixed period of time. And payments are often made monthly in equal installments—hence the name. Depending on the loan agreement, payments could be due more frequently.
Installment loans can be secured. That’s the case with car loans and mortgages. Installment loans can also be unsecured. That’s the case with student loans. A buy-now-pay-later loan, referred to as a BNPL for short, is another type of installment loan.
When you make installment debt payments, you’re paying what you borrowed and interest at the same time. Often, the amount of each payment that goes toward interest decreases as the loan is paid down. That process is known as amortization.
Debt Categories and Credit
These are just the basics. Depending on the type of debt—and what you plan to use it for—there could be different requirements or collateral. Some debt can be used continually while others begin with an end in mind.
The way different types of debt might affect your credit can vary too. But a tool like CreditWise from Capital One can help you understand more. It lets you monitor your VantageScore® 3.0 credit score and TransUnion® credit report. It’s free for everyone, and using it won’t hurt your credit scores.
Plus, with the CreditWise Simulator, you can explore how your credit scores might change if you do things like borrow money for a car or open a new credit card. Whether your debts are secured, unsecured, revolving or installment-based, it’s a good idea to know the facts before you borrow.
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We hope you found this helpful. Our content is not intended to provide legal, investment or financial advice or to indicate that a particular Capital One product or service is available or right for you. For specific advice about your unique circ*mstances, consider talking with a qualified professional.
Your CreditWise score is calculated using the TransUnion® VantageScore® 3.0 model, which is one of many credit scoring models. It may not be the same model your lender uses, but it can be one accurate measure of your credit health. The availability of the CreditWise tool depends on our ability to obtain your credit history from TransUnion. Some monitoring and alerts may not be available to you if the information you enter at enrollment does not match the information in your credit file at (or you do not have a file at) one or more consumer reporting agencies.
The CreditWise Simulator provides an estimate of your score change and does not guarantee how your score may change.
