Loans, such as mortgages, vehicle loans, personal loans, and credit card debt, are the most common types of debt. The borrower is obligated to repay the loan balance by a particular date, usually several years in the future, according to the terms of the loan. The amount of interest that the borrower must pay annually, stated as a percentage of the loan amount, is also specified in the loan terms. Interest is used to reward the lender for taking on the risk of the loan, as well as to encourage the borrower to repay the loan fast in order to reduce their total interest expense.
Credit card debt works similarly to a loan, with the exception that the borrowed amount fluctuates over time based on the borrower’s needs—up to a predetermined limit—and has a rolling, or open-ended, repayment date. Consolidating loans, such as student loans and personal loans, is an option.
Types of Debt
1. Secured Debt
Putting yourself in the position of a lender might help you understand secured debt. When someone asks for a loan, the lender must examine whether the debt will be repaid. Creditors can limit their risk by using secured debt. Because secured debt is backed by an asset (also known as collateral), this is the case. To put it another way, the collateral acts as a “security” for the loan.
Cash or property can be used as collateral. It can also be taken if borrowers do not make timely payments. Failure to repay a secured debt might result in additional consequences. Missed payments, for example, could be reported to credit bureaus. In addition, an unpaid debt may be referred to collections.
For example, a secured credit card needs a cash deposit before it may be used to make transactions. Consider it similar to the security deposit you’d put down when renting an apartment. Secured debt includes mortgages and auto loans. With these, the collateral is usually the purchased property, such as a house or a car. However, there is a silver lining to collateral: For the borrower, a lower risk to the lender could mean more attractive lending conditions and rates. Furthermore, some lenders may be less stringent when it comes to credit score requirements.
2. Unsecured Debt
When a debt is unsecured, there is no need for collateral. Consider student debts, credit cards, and personal loans. If you don’t have any collateral, your credit will usually play a significant role in determining whether you qualify for unsecured debt—though there are some exceptions, such as school loans.
Credit reports are used by lenders to assess your credit. That is true for the majority of debts. However, loan criteria may vary. Creditors typically consider factors such as your payment history and outstanding debt. Credit scores—another instrument that lenders may employ—are calculated using similar principles.
In general, the higher your credit score, the more possibilities you have. A higher credit score, for example, could help you qualify for bigger credit limits or cheaper interest rates on an unsecured credit card. Some credit cards may provide benefits such as cash back, miles, or points. Remember that a higher credit score does not guarantee that you will be approved for unsecured credit cards or other loans. And just because a loan is “unsecured” doesn’t imply it’s okay to skip payments. If you go behind on your payments, it may harm your credit and lead to collections or a lawsuit.
3. Revolving Debt
You may already be familiar with revolving debt if you have a secured or unsecured credit card. A revolving credit account is open-ended, which means you can charge and pay off your debt as many times as you like as long as the account is in good standing. Revolving credit includes personal lines of credit and home equity lines of credit.
If you qualify for a revolving credit line, your lender will set a credit limit for you, which is the most you can charge on the account. The amount of credit you have available changes month to month based on how much you utilise it. The minimum payment amounts may also alter month to month. Any unpaid debt will be carried over to the following payment cycle, along with interest. What’s the greatest way to avoid paying interest? Each time you receive a bill, pay it in full.
4. Installment Debt
In some respects, instalment debt varies from revolving debt. This sort of loan is closed-ended, unlike revolving credit. That is, it is paid back over a set length of time. And, as the name implies, payments are usually made monthly in equal increments. Payments may be needed more regularly depending on the loan agreement.
Installment loans are available. Car loans and mortgages are examples of this. Unsecured instalment loans are also available. Student loans are an example of this. Another sort of instalment loan is a buy-now-pay-later loan, sometimes known as a BNPL.
When you pay off a loan in instalments, you’re repaying both the principal and the interest. As the debt is paid down, the amount of each payment that goes toward interest usually decreases. Amortization is the term for this procedure.