Consumer Debt: Types, Advantages, and Disadvantages
10 MIN READ
Published April 07, 2023 | Updated November 06, 2023
Debt has become an integral part of people’s lives in today's time. From credit cards to mortgage loans, consumer debt is essential to a country's economy.
Let's understand the pros and cons of it, how to pay it off, and what to do if you are facing difficulties settling a consumer debt.
What is consumer debt?
Consumer debt is a type of debt owed by individuals. The motive for taking it is to utilize the money to consume goods rather than investments.
It is sometimes also called consumer credit or measured as household debt (the total of all consumer debts and mortgage loans in a household).
Simply put, the debts we take as individuals and use for individual or household consumption can be classified as consumer debt. On the other hand, non-consumer debts are generally business-related (business loans) or involuntary (tax debts).
In some cases (like filing a bankruptcy), consumer debts can also be considered non-consumer obligations depending upon how the funds were used.
For example, suppose an individual takes a student loan and uses a significant amount to pay living expenses rather than tuition fees. In that case, the loan will be classified as non-consumer debt.
Consumer debt can fall into two categories - secured debt and unsecured debt.
A secured debt is a type of debt that is backed by collateral. It acts as a security for the lender's investment, and if the borrower fails to repay the debt, the lender can legally seize and sell the collateral to collect the outstanding debt.
Unsecured debt is a type of debt that is not backed by collateral and is riskier for lenders. The lender can do little if the borrower defaults on the debt payments. Due to their risky nature, unsecured debts have high-interest rates.
Before granting any debt to a borrower, lenders check several financial factors to assess the repayment capability. These include:
- Credit Score
- Current Source of Income
- Credit History (previous loans, defaults, financial history, bank account statements, etc.)
- Debt to Income Ratio (percentage ratio of all your monthly debts and your gross income. It should be more than 35%)
Types of Consumer Debt
These are the most common types of consumer debts:
Credit Card Debt
The most common type of consumer debt which people come across is credit card debt.
Almost every adult in the country owns and uses a credit card in some capacity. These are mainly used for day-to-day purchases and paying monthly bills. The amount you owe on your credit card is called credit card debt.
According to a Federal Reserve Bank of New York report, Americans' total outstanding credit card balances stood at $986 billion in Q4 of 2022.
The best part of using a credit card is that it is a revolving debt. If you pay the outstanding bill on your credit card within the billing cycle, the balance replenishes to normal.
Another advantage of using a credit card is that most companies allow you to pay a minimum of your total outstanding amount for a billing cycle.
This can be helpful when you need more money to repay the outstanding bill in full. However, a hefty interest rate is also charged on the remaining balance, a double-edged sword.
Credit card companies can charge an interest rate of 15-30% annually (called purchase APR), and the rates offered will depend upon your credit score. For example, a person with a bad credit score will get higher interest rates than a good one.
A personal loan is a short-term, mostly unsecured debt taken by an individual to solve any instant financial needs.
It is an installment debt where you receive a lump sum amount and repay it in fixed monthly installments. The duration of these loans ranges between 12 and 84 months, and the interest rates are usually high and may go up to 36%.
Personal loans are usually taken to cope with unforeseen or urgent expenses such as home renovations, wedding expenses, medical bills, or debt consolidation.
22 million people had unsecured personal loans with an average debt of $10,749 in the third quarter of 2022.
A mortgage debt is a secured debt taken to purchase a property, where the property is the collateral. If the borrower fails to repay the debt, the lender can seize the property and auction it to collect the outstanding debt.
It is an installment debt where you receive lump sum money to purchase and repay the property in equal monthly installments. These are long-term debts, usually taken for 15 to 30 years, with low-interest rates between 5-8%.
The total mortgage debt in the country stood at a whopping $11.67 trillion in the third quarter of 2022, with a total of 52.2 million mortgage loan accounts.
Also sometimes referred to as vehicle loans, auto loans are secured debts used to purchase vehicles (cars, trucks, boats, etc.). While the borrower owns the vehicle, it also serves as the collateral for the debt.
It is a short-term installment debt that usually lasts between 12 to 84 months and has lower interest rates between 5-12%, depending upon your credit score.
As of the latest quarterly report of Q3 of 2022, the country had 81.2 million active auto loans, with the total auto loan balances in the country are at $1.55 trillion.
Student loans are among the leading sources of consumer debt in the country. These loans are taken by students looking to enroll in college for higher education.
It is an unsecured debt, and the creditor relies upon the goodwill and bright career of the borrower for repayment.
Most students take these loans from the Federal Government because of the low-interest rates, easy terms, and longer repayment duration.
While private lenders also offer these loans, their interest rates are twice or thrice more.
The federal rates for student loans range between 4.99% and 7.54%. The total student loan stood at $1.75 trillion (including national and private lenders) in the fourth quarter of the last year. About 92% of student loan debts were given by federal institutions.
Advantages of Consumer Debt
Here are a few advantages of consumer debt:
Flexibility in Spending
The most significant advantages of consumer debt are easy access to money and flexibility to spend. Many people live paycheck-to-paycheck, and having a consumer debt option like a credit card can help them pay for goods without cash.
A credit card's revolving debt ensures that a consumer can spend money and pay it back when the salary arrives.
If a person completes the payment in full within a billing cycle, they don't have to pay interest. It is an incredible tool for managing personal finances when used wisely.
Help with Long-Term Financial Goals
Most people need more money at once for significant expenses like buying a house or paying college tuition. This is where consumer debt comes in and helps with big purchases.
If you want to buy a home that costs $400,000, you can take a mortgage loan for 15 or 20 years and divide this massive amount into small, manageable monthly installments.
Similarly, a student loan helps many individuals go through college and build a promising career. These loans make education accessible for the average person and provide equal opportunity.
Consumer debts such as personal loans help you manage unforeseen and necessary expenses.
Suppose you have a wedding planned in the coming month and need more cash. You can avail of a personal loan to get instant money to repay it in installments according to your convenience.
Improve Credit Reports
The timely repayment of your debt installments casts a substantial positive impact on your credit score. A good history of paying bills on time can quickly build up your credit report.
You can access special offers with certain consumer debts like credit cards or auto loans. Perks such as discounts, airport lounge access, split payments, cash rewards, etc., are usually offered to borrowers with a fair credit score.
Consumer credit increases consumer spending, introducing more money into the economy. People use debts to manage their short and long-term financial needs, hence strengthening a country's economy.
Disadvantages of Consumer Debt
On the flip side, consumer debt has a few disadvantages as well:
Easy access to consumer loans may promote overspending. Some people may misjudge their financial condition and put on more debt than they can repay.
This can eventually lead to a vicious cycle of debt overburden resulting in a bad credit score, high delinquency rates, pestering by debt collectors, falling for predatory loan schemes, and even bankruptcy.
Some forms of consumer debt, such as credit cards and personal loans, have high-interest rates, which can significantly increase repayment.
Similarly, long-term obligations such as mortgages and student loans offer low-interest rates, but you can end up paying 1.5x to 2x the principal amount over the long term.
What is Delinquency?
Delinquency is when a borrower does not pay back the debt. A loan is considered delinquent when any repayments are not made consecutively for 90 days.
The number of obligations where borrowers default is represented as the delinquency rate. The U.S. Federal Reserve released data showing a delinquency rate of 2.08% on all consumer debts.
How to pay off consumer debt
Follow these tips to pay off your consumer debt with ease:
- Never take more debt than what you can manage. Always have a plan in your mind before taking on any debt.
- Allocate a significant portion of your income towards paying off debts. Try to close debts with high-interest rates first. This will ease your financial burden and also improve your credit score.
- If you have multiple debts, consolidate them in one debt consolidation loan like a personal loan or balance transfer credit card.
- Set up an automatic payment facility (like autopay) so you never forget and miss your debt payments.
Suppose you have fallen into a debt trap and cannot seek a way out. You should consult with a debt relief company and check out their options for the best debt relief programs on the market.
Such programs help you settle your debt with creditors by reaching a mutual agreement and deciding on a final debt settlement amount. However, always work with credible debt relief companies like Turbodebt to avoid scams and losing your valuable financial data.