Most Americans have some type of debt in their lives. However, debts vary widely with regard to the way they work, their terms, and their impact on your financial health. Debt comes in several forms, including mortgages, student loans, credit cards, or personal loans, but most debt can be classified as secured or unsecured and as revolving or installment. Learn more about the different categories of debt and how they work.
Key Takeaways
- The main types of personal debt are secured debt and unsecured debt.
- Secured debt requires collateral, while unsecured debt is solely based on an individual's creditworthiness.
- A credit card is an example of unsecured revolving debt and a home equity line of credit is a secured revolving debt.
- You can also classify debt by its product name, such as mortgages, credit cards, personal loans, or auto loans.
Secured Debt vs. Unsecured Debt
Secured debt is debt backed by an asset used as collateral. The asset is pledged to the lender in case the borrower does not repay the loan. If the loan isn't paid back, the lender has the option to seize the asset.
A car loan is an example of a secured debt. A lender supplies you with the cash necessary to purchase it, but also places a lien, or claim of ownership, on the vehicle's title. If you fail to make payments, the lender can repossess the car and sell it to recoup some of the funds. Secured loans generally have lower interest rates because the collateral lowers the risk for the lender.
Unsecured debt does not require collateral. When a lender makes a loan with no asset held as collateral, it relies on the borrower's ability to repay the loan.
With unsecured debt, the borrower is bound by a contractual agreement to repay the funds, and if there is a default, the lender can go to court to reclaim any money owed. However, doing so comes at a great cost to the lender.
Because it is more risky for the lender, unsecured debt generally has a higher interest rate. Some examples of unsecured debt include credit cards, signature loans, and medical bills.
Revolving Debt vs. Installment Debt
You can also categorize debt by whether it is revolving or installment.
Revolving debt is debt that is open-ended, meaning you can reuse it once you pay down your balance. With revolving debt, you get a maximum credit line and then you can spend up to that limit as many times as you need. The available credit you have will fluctuate depending on how much credit you've used. You must make at least the minimum payments and the remaining balance will then transfer over to the next month with interest.
Installment loans are closed-ended. They work by providing a lump sum, which you then repay the lender in regular payments that are typically the same amount each month and for a set time.
Fixed-Rate vs. Variable-Rate
Fixed-rate debt and variable-rate debt differ in the way their interest rates are structured. With fixed-rate debt, the interest rate remains constant throughout the entire term of the loan. This provides borrowers with predictability and stability in their monthly payments since the interest rate does not fluctuate with changes in the market.
On the other hand, variable-rate debt is characterized by interest rates that can change from time to time based on market conditions. These fluctuations introduce an element of uncertainty into monthly payments, For some people, this uncertainty is scary and the reason they stay away from variable-rate debt. For others, it's an opportunity to maybe have smaller payments in the future if markets turn their way.
Short-Term Debt vs. Long-Term Debt
Short-term debt and long-term debt differ based on their repayment periods. Short-term debt typically has a maturity of one year or less, while long-term debt has a repayment period exceeding one year.
This distinction is usually more important for companies, especially those who have to published external financial statements. Classifying debt between these two categories is a requirement of GAAP. Individual consumers should still be mindful of the varying terms of debt, as long-term debt carries with it more obligation, potentially more interest, and more risk.
Callable Debt vs. Non-Callable Debt
Callable debt and noncallable debt differ in the issuer's ability to redeem or "call" the debt before its due. Imagine you have a loan. If it's callable, it gives the issuer the right to redeem or require full payment prior to the due date. Noncallable debt lacks this feature, meaning the issuer cannot redeem the debt before the maturity date. Callable debt is usually associated with corporate bonds, and it's extremely rare and even unheard of for consumer debt to be callable.
The Federal Reserve tracks different types of debt. For example, in Q3 2023, revolving consumer credit increased 10.2% with over $1.2 trillion dollars outstanding.
Specific Types of Loans
In addition to the factors that were talked about above, loans can pertain to a specific use. For example, when you go to school, you may take out a student loan; when you buy a car, it's a car loan. Aside from just naming the type of debt whatever it's going to be used for, there are some specific characteristics for some of these types of loans.
Credit Cards
Credit cards are a type of revolving debt. With this debt, you can borrow up to the maximum limit on a recurring basis. When you pay down your balance, you can use that credit again. You credit limit will depend on a number of factors, including your income and credit score.
Credit cards, which are generally unsecured but can also be secured with a deposit, tend to have fairly high interest rates. Some credit cards offer benefits like rewards. A line of credit is loan that is similar to a credit card as it is revolving debt.
Mortgages
Mortgages, the most common and largest debt in the U.S., are loans made to purchase homes, with the property serving as collateral.
A mortgage typically has one of the lowest interest rates of any consumer loan product, and the interest is often tax-deductible if you itemize your taxes. Mortgage loans are most commonly issued at 15- or 30-year terms.
Student Loans
Student loans are loans used to pay for education expenses like tuition and room and board. They are issued in a lump-sum payment, and then the borrower is responsible for making repayments in regular amounts, typically after the student graduates.
Student loans can come from a variety of types of lender, including the federal government. Unlike other types of debt, you usually cannot discharge student loans in bankruptcy. It can only be done by making a special request of the court and getting its approval. This is not very common.
Auto Loans
Car loans are a type of installment loan that is secured by the vehicle you are purchasing. You can get an auto loan through a bank or through a lender connected with a car dealership.
Car loans give you money in a lump sum that you pay back with interest over time, usually from three to six years. Interest rates on auto loans are generally lower than for personal loans because auto loans are backed by the vehicle, which the lender can repossess if you fail to pay.
Other Types of Debt
Personal loans, medical debt, and lines of credit are among the many other types of debt. for individuals. Larger companies may take on corporate debt by issuing bonds, which can trade as securities.
Having lower debt can generally help your credit score and keep you in good financial health, but not all debt is considered bad. Taking on debt can be a good financial move if it can help you build long-term wealth. Debt that is not healthy is debt that has a high interest rate that compounds over time.
Does a Secured Loan Hurt Your Credit?
A secured loan can impact your credit in several ways. When you apply for the loan, your credit score will likely take a brief hit. If you make payments on the loan on time, then the loan could help your credit score in the long-term. However, if you fail to make payments on time, your credit score will decline.
What Is the Most Common Debt?
The most common debt by total amount of debt in the U.S. is mortgage debt. Other types of common debt include credit card debt, auto loans, and student loans.
What Happens If Unsecured Debt Is Not Paid?
If unsecured debt is not paid, you can face a number of negative consequences. Unsecured debt is not backed by collateral, so lenders cannot take your assets. But if you do not pay unsecured debt, you could face fees, penalties, and a wage garnishment. Not making your payments to lenders on time will typically result in a lower credit score, which will make it more difficult for you to get approved for loans and other financial products.
The Bottom Line
Different types of debt include secured and unsecured debt or revolving and installment. Debt categories can also include mortgages, credit card lines of credit, student loans, auto loans, and personal loans. If you are struggling to pay your debt, you may want to consult with a financial advisor to review your options like budgeting, loan consolidation, or bankruptcy.
As a seasoned financial expert with a deep understanding of personal finance and debt management, I can confidently guide you through the intricacies of the concepts discussed in the article. My expertise is grounded in practical experience and a comprehensive knowledge of the financial industry.
Secured Debt vs. Unsecured Debt: Secured debt involves collateral, providing lenders with an asset-backed security in case of default. The article rightly points out that car loans are a classic example of secured debt. The presence of collateral reduces the risk for lenders, resulting in lower interest rates. On the flip side, unsecured debt relies solely on the borrower's creditworthiness, making it riskier for lenders. As mentioned, credit cards, signature loans, and medical bills fall into the category of unsecured debt, often associated with higher interest rates.
Revolving Debt vs. Installment Debt: The distinction between revolving and installment debt is crucial. Revolving debt, exemplified by credit cards, allows borrowers to reuse the credit line once the balance is paid down. Minimum payments are required, and the remaining balance accrues interest. On the other hand, installment debt, such as mortgages or car loans, involves fixed regular payments for a predetermined period.
Fixed-Rate vs. Variable-Rate: The article rightly notes the difference between fixed-rate and variable-rate debt. Fixed-rate debt provides stability with a constant interest rate throughout the loan term, ensuring predictable monthly payments. Conversely, variable-rate debt exposes borrowers to market fluctuations, leading to uncertain monthly payments. This section adeptly captures the preferences and risks associated with each type.
Short-Term Debt vs. Long-Term Debt: The distinction between short-term and long-term debt is crucial for understanding the repayment period. Short-term debt typically matures within a year, while long-term debt extends beyond a year. The article correctly emphasizes the significance of this classification, particularly for companies following GAAP. Individual consumers should be aware of the implications, considering the varying terms, interest rates, and risks associated with each.
Callable Debt vs. Non-Callable Debt: The rare concept of callable and non-callable debt is elucidated well. Callable debt gives the issuer the right to redeem or demand full payment before the maturity date, more common in corporate bonds. The mention that consumer debt is seldom callable aligns with the rarity of this feature in personal finance.
Specific Types of Loans: The article covers specific loans, such as credit cards, mortgages, student loans, and auto loans. It provides insightful details, such as the revolving nature of credit cards and the long-term nature of mortgages. The inclusion of information on student loans' unique characteristics, such as difficulty in discharging through bankruptcy, demonstrates a nuanced understanding of these financial instruments.
The Bottom Line: The conclusion effectively summarizes the key concepts discussed, emphasizing the importance of seeking financial advice when struggling with debt. The mention of options like budgeting, loan consolidation, or bankruptcy showcases a practical approach to debt management.
In summary, the article provides a comprehensive overview of various types of debt, demonstrating a nuanced understanding of the financial landscape. If you have any further questions or need clarification on specific points, feel free to ask.
