Maybe you've heard of this thing called debt. It may have come up a time or two in conversation. We talk a lot about student loans, mortgages, car loans, and credit cards, all different ways to be in debt. We also know how emotionally charged owing debt can be.
But we don't often talk about what debt is, or that there are levels to it. I was inspired to write this post after reading Finance for the People by Paco de Leon, who includes a great visual illustration of the different types of debt. We need to understand what debt is so we can effectively tackle it.
Let's start with a basic definition of debt: "something, typically money, that is owed or due." Now that we have the basic definition, let's break it down into the types of debt our (American) society employs.
Secured Debt: debt backed by an asset or collateral, reducing the risk to the lender. Typically the financing terms of the debt (interest rate, period of repayment, etc.) are more favorable for the borrower because the risk is lower to the lender. Examples of secured debt are mortgages, auto loans, and secured credit cards.
Unsecured Debt: debt that is not backed by an asset or collateral. Because the risk is higher for the lender, it is harder for people to qualify for unsecured debt, and the financing terms can be less favorable for the borrower. Student loans, personal loans, and credit cards are all examples of unsecured debt.
Revolving Debt: credit you can charge against and pay down repeatedly, in a revolving fashion. Because this debt is open-ended, it usually comes with a credit limit for how much you can spend. You can spend up to that amount and not past it. Repayment happens on a pre-determined interval (i.e. monthly), and the minimum amount varies based on how much you've spent. If you don't repay in full, the remaining balance carries over, with interest. Types of revolving debt are credit cards, personal lines of credit, and home equity lines of credit. Interest rates on revolving debt are typically higher than interest rates on installment debt but are only applied if you don't pay each repayment in full.
Installment Debt: close-ended debt, which means "that it is repaid over a fixed period" (Capital One). It's typically repaid in regular, and equal installments. The regular installments include a percentage of what you've borrowed coupled with interest for the privilege of borrowing the money. Interest rates are typically lower on installment debt than revolving debt and are applied for every installment. The faster you pay off the installment debt (paying additional payments beyond the predetermined time or amount), the less interest you'll pay over time.
Those are the four most common types of debt, and the different categories can be combined. For example, student loans are unsecured installment debt, while mortgages are secured installment debt. Secured credit cards are secured revolving debt, while regular credit cards are unsecured revolving debt.
If you need to utilize debt, the best type of debt to be in is secured installment debt. Because the debt is secured, you'll have more favorable financing terms, and because it is installment, there is a pre-determined amount you borrow, that you pay off in fixed regular payments. This debt is easier to budget for, and because it is a pre-determined amount borrowed, does not rely on your willpower not to borrow more.
The worse type of debt to be in is revolving, unsecured debt. This debt works for people who set limits and stick to them and are not using this debt to support survival (i.e. they have enough to cover their living costs). If you are someone who is not great with setting and sticking to limits or would use this debt to stretch your lifestyle (be honest with yourself!) revolving unsecured debt is not for you.
Knowing how different types of debt work allows us to make better and more informed decisions about what type of debt we are willing to be in. It can also help us determine if we need/want to use debt at all. Like any other concept, the definition (and types) of debt is devoid of the emotional reality that comes from owing or being owed money. You should also consider your current and potential future emotional state when determining if using debt is right for you.
If you're already in debt or don't have a choice about using debt (i.e. you don't have enough to survive) it's important to acknowledge the facts. Just because I owe money, or have to use debt, does not make me an inherently bad person. And what this post provides you is the knowledge to focus on reducing higher-risk debt, and utilizing lower-risk debt instead.