What Are The Main Types of Debt
9 MIN READ
Published March 29, 2023 | Updated December 16, 2023
Debt is an integral part of the lives of nearly two-thirds of all Americans. At some point in your life, you'll probably take on debts to purchase an important item such as a house or a car.
For example, most students will take a student loan to pay college tuition, and most homeowners take on mortgage debt.
Debt is often the exchange of assets and acts as an essential driver of the modern financial ecosystem.
The best approach to dealing with debt is to stay prepared and get aware of the different types of debt and their implications. Keep your eyes focused on the text, and we’ll guide you through all the ins and outs of the different types of debt and how they work.
What Is Considered Debt
Simply put, debt is anything (usually money) that is owed by one party to another. Let’s understand this with the help of an example.
Mike is a professional with a decent job, and he currently lives in a rented property. He has a seemingly stable financial future and plans on buying a house. However, he does not have the amount of money needed to buy a home, so he decides to borrow it from the bank.
The money he receives from the bank is a debt, more specifically called mortgage debt. Mike can use the funds to purchase the house and repay the money he owes to the bank with interest over a specific period of time.
The party that gives the debt is called ‘the creditor,’ and the party which receives and owes the debt is called ‘the debtor.’ The terms and conditions for the allotment and repayment of debt are pre-decided and sealed with a legal contract.
The creditors use debt as an investment opportunity and usually charge interest on it to appreciate the value of their investment.
Similarly, the debtors use debt to fulfill their immediate financial necessities and repay the principal amount with interest for the facility.
These are the most common types of debts:
- Loans (car loans, student loans, personal loans, etc.)
- Credit Cards
- Mortgage Loans
- Payday Loans
- Lines of Credit
- Bonds (corporate and government)
Unsecured vs. Secured Debt
Depending upon the risk involved for the creditor and terms of allotment, all debt can be classified into two broad types: unsecured and secured. You must also learn about the term ‘collateral’ before you can understand the difference between the two.
Collateral refers to a commodity (money, property, gold, etc.) with value, which can be held as a guarantee by the creditor against the debt.
A collateral assures the creditor that if the debtor fails to repay the debt, the creditor can use (sell or acquire) the collateral to recover the given amount.
Unsecured debt is a type of debt that is not protected by collateral. This means that the debtor does not have to deposit or lien any existing assets to the creditor to guarantee their debt repayment.
- Unsecured debts have high-interest rates due to the absence of collateral
- These are risky for creditors
- Some common examples are credit cards loans, student loans, and personal loans
These debts are protected by collateral against the disbursed amount. A typical example of secured debt is a car loan.
The creditor provides the debtor with a lump-sum amount to purchase the car but places a claim of ownership on the vehicle if the debtor fails to repay the loan within the agreed period.
- Secured debts have lower interest rates due to collateral
- Relatively safe investments for creditors
- Common examples include a car loan, mortgage debt, and gold loan
Revolving vs. Installment Debt
Another classification of debt is based on the repayment schedule. The money borrowed in debt can be repaid in equal regular sums or continually used with partial payments.
The best example of revolving debt is the repayment schedule of your credit card.
These kinds of debts are open-ended and offer the debtor a monthly credit limit (money that can be borrowed each month). The debtor can use a portion of it or the total credit limit and pay it before the billing cycle ends (usually a month). The credit limit is then replenished for the next month.
There’s also an option to pay a portion of the outstanding amount (used credit limit), usually called the minimum payment. However, higher interest rates are accrued on the remainder and it carries forward to the coming months.
Revolving debt is best for businesses or salaried people who are sure of receiving and repaying the spent amount within a specific time. The best use of these kinds of debt is always paying the outstanding in full.
The most common examples of revolving debt are credit cards and lines of credit.
Installments are the most common mode of repayment for debts. In this close-ended arrangement, the debt is given for a specific period (months or years) on a fixed or floating rate of interest which can vary based on different factors.
The final amount to be repaid by the debtor at the end of the debt term is calculated and divided into monthly/weekly installments (sometimes called EMI). Failure to repay the installments on time can result in a low credit score, legal action, or seizure of assets.
Installment debts can be secured or unsecured. Some common examples include car loans, home loans, student loans, and personal loans.
Types of Consumer Debt
Let’s look at the different types of consumer debts and understand them in detail. These have respective interest rates, tax implications, and credit score impacts.
Credit Card Debt
About 191 million Americans own a credit card, which is also one of the top payment methods for making purchases. Plus, American citizens’ total credit card debt is nearing a trillion dollars as of Q3 of 2022.
Credit card debt is a revolving and unsecured debt given to a person based on their good credit score. The bearer of the credit card can pay the outstanding amount within each billing cycle or pay interest on the due amount.
Interest rates for credit card debts are usually exorbitant because they are unsecured and can cost anywhere between 10 to 25 percent a month.
If you use a credit card, you must try to spend only what you can pay within the billing cycle. Additionally, there are no tax implications, and timely payments will help you with your credit score.
The leading source of debt for North American citizens is mortgage debt. These are secured and installment debts which are usually agreed upon for a period of 15 to 30 years. The interest rate can be fixed or floating (changes yearly) and usually comes at three to five percent per year.
Typical repayment for installments for these debts is once a month, and the interest paid on the mortgage is tax-deductible.
Personal loans are unsecured, installment loans usually taken by salaried or self-employed individuals or small business owners. An applicant should have a good credit score, a reliable source of income, and an excellent financial history to be eligible for a personal loan.
These loans typically have a duration of 12 to 60 months and interest rates ranging from 4% to 36%. Interest paid on a personal loan is not tax-deductible. However, if somebody had such a loan canceled or forgiven, it may count as taxable income.
Student loans make up a big chunk of debtors in our country. Most students take federal student loans to pay for their college tuition. These are unsecured loans with interest rates ranging between 4.99% to 7.54% on the principal amount of debt.
These loans are generally disbursed for ten years, but the repayment plans are flexible compared to other loans. Interest paid on student loans is tax-deductible, and these usually cannot be discharged when filing bankruptcy.
Auto loans are secured, installment loans where the creditor treats the vehicle as collateral. These loans usually have a term of three to six years, with interest rates ranging between 5.5% and 10%.
The creditor is legally allowed to seize the vehicle if the debtor fails to repay the loan. Getting a good deal for interest rates depends mainly upon the applicant’s credit score. Payments made for auto loans are not tax-deductible.
Medical debts are unsecured debts incurred when an individual cannot pay their medical bills in full with a healthcare provider. Suppose someone gets treated at a hospital and comes up with a billed amount they cannot pay.
Such individuals can work out a repayment plan with the hospital’s billing department and negotiate a lower service price. The interest rates on such debts can range from 5% to 36%, and the payments are tax-deductible.
Qualified medical expenses in such debt which exceed 10% of the individual’s total gross income are eligible for deduction in federal taxes.
A good health insurance plan is always the best option to avoid medical debt. However, in some cases, insurance providers do not process claims quickly, and that is where a medical debt can help.
A tax debt results when an individual fails to pay their due taxes, files wrong taxes, or the IRS changes their taxes. This debt is owed to the IRS, and the interest rate ranges between 3% and 5% with daily compounding.
Overlooking tax debt for an extended period can result in a significant amount owed to the authorities. The best approach to avoid this is to file taxes properly under the guidance of a qualified tax consultant.
How To Pay Off Debt
Too much debt can cripple your personal finances and, eventually, your personal life. Follow these expert tips and advice to pay off your debt effectively:
- Never take on more debt than you can pay. Stay aware of your current financial situation and avoid taking debts for unnecessary expenses. Always have a plan before taking any debt. This means ensuring you have enough cash to pay your auto loan each month, as you don't want to end up having to make payments for your car with a credit card.
- Try to pay off existing debts fast. Dedicate a significant portion of your monthly income towards debt payments. Pay credit card debts in full as soon as possible and avoid going on revolving debt plans.
- Maintain a good credit score and credit history. It plays a vital role in deciding the interest rates which you will be offered for new debts.
- Consolidate multiple debts into one, especially if you find cheaper interest charges.
Now that you know about the different types of debts and their details, it is time to make a plan. If you are looking to take a loan from financial institutions, the best route is to find and compare interest rates. Some debts can also help with tax-deduction while you repay them.