Related Articles
Debt: Definition, Types and Considerations
Understanding debt is the first step to helping to managing it.
The word “debt” often has a negative connotation. And while there are certainly some debts that are avoidable, others may be beneficial to your finances.
For example, some types may help you boost your credit score or make it easier to finance certain purchases, like a new home. It’s important to use debt to your advantage to help strengthen your finances.
Let’s look at how debt works and the types you’re likely to encounter.
Key Takeaways
Having different forms of debt, like loans, credit cards, and lines of credit, may help boost your credit score.
Make all debt payments on time and in full each month to avoid penalties and negative marks on your credit report.
The most common types of debt include secured, unsecured, revolving, and installment.
What Is Debt?
Debt is money that one party owes to another1 and in America, debt levels are on the rise. At the end of 2023, the average household had $103,358 in debt.2 This debt takes several forms, including:3
Mortgages
Student loans
Credit cards
Personal loans
Car loans
Using debt responsibly helps build your credit history and may make it easier to reach financial milestones. That said, it isn’t free, and lenders expect you to pay interest on what you borrow. That interest is expressed in terms of an Annual Percentage Rate (APR).
Borrowing only what you need and making on-time payments could boost your credit score and help you get closer to achieving financial wellness.
Revolving vs Installment Debt
Most debt falls into two types: revolving and installment. Let’s look at the differences between the two and how paying them off works.
Revolving: Revolving debt includes things like credit cards and home equity lines of credit (HELOCs). They typically have a minimum payment that’s due each month, and that payment amount may change depending on the total balance of the debt—typically it’s a percentage of the total. It’s a good idea to pay more than the minimum payment whenever possible, and ideally, pay off your balance in full each month.4
Installment: Installment debts, like loans, typically give you a lump sum of money upfront and usually have a monthly payment that doesn’t change unless you have a variable rate. The amount is predictable, helping make it easier to budget for your payments.5
Secured vs Unsecured Debt
Other terms you may hear associated with debt are secured and unsecured. Both revolving and installment debts could be secured or unsecured.
Secured: Secured debts are backed by assets, such as your home or vehicle. These assets serve as collateral for the loan, meaning the lender could take the item if you fail to repay the debt. These debts often have lower rates since they pose less risk to the lender.
Unsecured: Unsecured debts aren’t backed by collateral and are approved based on the borrower’s creditworthiness. Since the lender is taking on more risk, rates tend to be higher, and borrowers often have to meet more strict requirements for approval.
Is Credit the Same as Debt?
Credit is related to debt, but it’s not the same thing. Debt is the amount of money you owe whereas credit is the amount of money you’re able to borrow. A common example is your credit card limit. Your limit is the maximum amount you’re able to charge to the card or borrow from your credit card issuer.
For example, say you have a credit card with a limit of $20,000 and are carrying a balance of $5,000 on that card. Your total debt on that card is $5,000 and the total available credit you have is $15,000. If you pay down your balance, your available credit goes up and your debt goes down.6
Is a Loan the Same as Debt?
The line between loans and debt may seem confusing, but it’s actually simple. Loans are a type of debt, much like a raven is a type of bird. And just as not all birds are ravens, not all debts are loans.
Paying Off Debts
It’s important to make your payments on time each month. Missing one or multiple payments may cause your credit score to drop and could make it harder to qualify for new loans in the future.
It’s also important to make at least the minimum payment on all debts each month. If you’re trying to reduce your overall debt burden, you probably want to pay more than the minimum to make a dent. But how do you decide what to pay down first? Many experts recommend focusing on the debt with the highest APR first and making larger payments there (while still paying minimums on everything else). This is also known as the debt avalanche approach. Starting with the highest rate may help you save on interest in the long run.
Keep in mind that most credit cards have higher rates than loans like your car, home, or even student loans. Once you pay off the debt with the highest APR, focus on the debt with the next highest, and so on.
Is Debt Good or Bad?
Debt in and of itself isn’t good or bad. Some debts, like student loans or home loans, may be beneficial for your long-term well-being as they help you access education and help give you a safe place to call home—both of which could have significant returns in value over time.
But debt could be misused. If you borrow more than you’re able to pay back or interest starts to pile up, it may lead to serious stress and other financial problems. The more interest you’re being charged, the larger your balance could become, which may make it hard to get out of debt.
If you’re trying to get out of debt, you have a few options. You could consolidate your debt with a consolidation loan, like a personal loan, at a lower APR than your credit cards. You could also use a budgeting method like the debt snowball or debt avalanche method to pay debts off strategically.
It all comes down to how you use the debt you take on. If you’re responsible and careful with what you borrow, debt may be a tool to help you get ahead.7
Final Thoughts
Many people use debt as a strategic tool to help reach their financial and life goals. By consistently making on-time payments, only borrowing what you need and maintaining a healthy budget, debt may help you establish a solid financial foundation.
Remember that debt management isn’t just about borrowing money, it’s also about making informed choices that align with your financial goals. By using debt responsibly, you may put yourself on the path to a better future.