Debt can be a double-edged sword. On the one hand, it can help you achieve your financial goals faster and more efficiently. On the other hand, when you have it, you’re working for a creditor, not just yourself.
Which means your goals will take longer to reach.
This is why it’s important to understand the different types of debt available to you before you go apply for another credit card or take out personal loans.
So in this article, we’ll explore how to manage debt responsibly and the 4 kinds of debt you need to be aware of, including the pros and cons of each.
How to handle all types of debt responsibly
Before we get into the types of debt, I want to offer a few quick tips for handling debt responsibly:
- Pay on time and at least the minimum monthly payment
- If you can, pay more than one a month, even if it’s just the minimum split in two
- If you struggle to keep up with your payments, be proactive and let the creditor know. They will often work with you to lower your monthly payments
- Sell it if you can’t afford to keep it
- Instead of buying with credit, wait until you have enough cash to purchase outright
Warning: If you fail to pay your bills, your assets aren’t the only things at risk. You could also destroy your credit score, be harassed by debt collectors, or incur an avalanche of interest. So do your best to stay current.
4 types of debt you need to know
Not all debts are created equal. Some types of debt can be beneficial, while others can be financially harmful in the long run.
The next sections discuss the various types of debt and their characteristics, so you know what you’re signing up for before going into debt.
Include
- Secured debt
- Unsecured debt
- Revolving debt
- Installment debt
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Secured debt
Secured debt is backed by an asset, also known as collateral, such as your house or vehicle. If you cannot repay the loan, the lender has the right to seize the collateral and use it as repayment.
As a result, you don’t actually own the items until the debt is paid off, so it’s like you’re renting someone else’s stuff.
A secured loan may be easier to obtain since lenders feel they can recoup their losses should the borrower default. This confidence makes lenders more likely to approve a loan or credit card, often at a lower interest rate.
Examples of secured debt
- Security and application deposits made when renting an apartment
- Mortgage debt
- Auto loan
- Pawnbrokers
Pros & cons of secured debt
| Pros | Cons |
|---|---|
| You may be approved to borrow higher amounts since the debt is less risky to the lender May be easier to qualify if you have a bad credit score or no credit history | If the value of the asset used as collateral does not equal the value of the loan, you may have to pay the remaining balance in cash if you are unable to pay off the debt Cash received from secured debt is often restricted to an explicit item rather than a lump sum of cash |
Unsecured debt
Unsecured debt is based solely on the ability of the borrower to make payments and is not tied to collateral.
When someone takes out unsecured debt, they do so at their own risk of defaulting and will be held accountable for whatever funds are borrowed and not repaid. As such, you’ll want to make sure debt payments are included in your budget. This way, you can get rid of your unsecured debt while also putting extra money towards savings or other financial goals.
Examples of unsecured debt
- Student loan debt
- Medical bills
- Most credit card debt
- Payday loans
Pros & cons of unsecured debt
| Pros | Cons |
|---|---|
| No collateral, so you won’t lose any personal property as a result of not making payments, nor do you need to have something to be able to get the loan in the first place May be a quicker application process | Higher interest since it’s riskier for the lender Often requires higher credit than with a secured card because it’s riskier for the lender |
Revolving debt
Revolving debt is open-ended, allowing you to borrow, repay, and re-borrow repeatedly.
With revolving debt, you are given a spending limit, the maximum amount of money you can use. However, interest generally accrues on any remaining balance if not paid in full each month, so it’s key to be aware of how much interest could accumulate over time when taking out revolving credit.
Examples of revolving debt
- Credit card debt
- Personal lines of credit
- Home equity loan
Pros & cons of revolving debt
| Pros | Cons |
|---|---|
| Keeping up with your payments is hugely beneficial to your credit score as it shows you can borrow and repay responsibly You don’t have to reapply every time you need money so that you can cover unexpected expenses | Monthly payments vary according to how much you owe, so it may be hard to budget for May have a lower limit than if you went with another type of debt |
Installment debt
Installment debt is a set amount paid back over a set period, typically in equal monthly installments. So you’re paying both the principal and the interest at the same time.
Installment debt can be a helpful tool if you need cash for something specific, as it typically comes with lower interest rates than credit cards. Because of this, installment debt is often used to purchase large items that would be otherwise unaffordable if charged to a high-intrest credit.
Examples of installment debt
- Personal loans
- Home renovation loans
- Car loan
- Student debt
Pros & cons of installment debt
| Pros | Cons |
|---|---|
| Payments are the same amount every month, which makes them easy to budget for You can often get a higher credit limit | Typically end up paying more than you borrow, thanks to the need to pay interest Easy to fall into more debt since, on the surface, it looks like you only have to make a small monthly payment |
The Impact of Debt on Credit Scores and Creditworthiness
When discussing different types of debt, it’s essential to understand how debt can affect your credit scores and overall creditworthiness.
Credit scores play a vital role in financial transactions, as they are used by lenders, landlords, and even potential employers to assess your creditworthiness and determine whether to extend credit or offer favorable terms.
Credit utilization
One crucial factor influencing your credit score is credit utilization.
In other words, the percentage of available credit you’re currently using.
High utilization negatively impacts your score and indicate potential financial strain. To avoid damaging your credit score, target a credit utilization rate of 30% or lower.
Excessive debt, especially revolving debt like credit card balances, can result in high utilization rates and lower credit scores.
Payment history
Payment history is a major player in your credit score.
Consistently making timely payments on all your debts, including loans, credit cards, and other forms of debt, demonstrates responsible financial behavior. On the other hand, missed or late payments can lower your credit score and indicate a higher credit risk to lenders.
It’s crucial to prioritize making timely payments to maintain a positive payment history and preserve your creditworthiness.
Debt-to-income ratio
Lenders often assess your debt-to-income ratio (DTI) when determining your creditworthiness.
DTI compares how much you monthly to your monthly income and helps lenders evaluate your ability to manage additional debt responsibly.
High debt levels in proportion to your income can suggest an inability to payback future financial obligations. Keeping your DTI ratio below 43% is advisable to enhance your chances of obtaining credit on favorable terms.
Credit mix
Having a diverse credit mix can positively impact your credit score.
Lenders prefer to see a mix of debt types, including things like installment loans (e.g., mortgages, car loans) and revolving credit (e.g., credit cards).
Demonstrating the ability to responsibly manage various forms of debt can enhance your creditworthiness.
However, it’s important to note that taking on unnecessary debt solely to improve your credit mix is not recommended, as it can lead to financial strain.
Credit history length
The length of your credit history also plays a role in determining your creditworthiness. While it’s essential to manage debt responsibly, it’s equally important to maintain a credit history over time.
Closing older credit accounts or frequently opening new accounts can shorten your credit history, which may hurt your credit scores.
If you have old credit accounts with positive payment history, keeping them open is generally beneficial to maintain a longer credit history.
Get familiar with the different types of debt to get your finances in check
Debt is a powerful financial tool that can be used to achieve personal and professional goals. However, it is important to understand the different types of debt, from secured and unsecured debt to revolving and installment loans, and their characteristics to avoid falling into financial traps. Individuals can use debt responsibly and wisely to improve their financial health and achieve their long-term goals.
