4 Types of Debt You Need to Know
Understanding the different types of debt is the first step in digging your way out – no matter the amount! Below are the four main types of debt you should know.
- The four main types of debt are credit cards, auto loans, mortgages, and student loans.
- Debt is your total amount of outstanding loans and an obligation for you to pay back the money you borrowed.
- Your debt’s interest rate is the rate for your debt or loan.
- Annual Percentage Rate or APR is the annual interest rate and total cost of borrowing.
- Secured debt is secured by collateral such as a car.
- Unsecured debt is like credit cards. It’s not backed by anything so interest rates are higher.
- A credit card is a card issued by a financial company. You borrow money to make purchases when you swipe the card.
- Auto debt is created by taking out an auto loan to purchase a vehicle.
- A home loan or mortgage helps you finance a home that you couldn’t necessarily purchase upfront.
- Student loans are either federal or private. The money borrowed is used to pay for college expenses.
What is Debt?
Debt is your total amount of outstanding loans and an obligation for you to pay back the money you borrowed. This money could be owed to a credit card company, a bank, or even family members or friends.
It can either be secured or unsecured. Secured debt is secured by collateral such as a car. This means that the bank or lender can claim your collateral if you don’t make payments. Unsecured debt is like credit cards. It’s not backed by anything so interest rates are higher.
Whether secured or unsecured, debt stems from not having enough money to cover expenses or other purchases. The problem with debt is how fast it can grow. Thanks to interest and other fees, your original loan amount can become hundreds to thousands more dollars over time.
APR vs. interest rate
Your debt’s interest rate is the borrowing rate for your debt or loan. For example, say that you borrow $100,000 to buy a home. Your interest rate is 4%. In addition to the $100,00 you borrowed (or the principal balance), you’ll also have to pay back the interest over time.
Annual Percentage Rate or APR is the annual interest rate and total cost of borrowing. It includes fees such as origination fees. In other words, it’s the true cost of borrowing money. APR is always higher than the interest rate.
Debt can typically be paid off through monthly payment plans, but it can take a while thanks to your APR and if you only make minimum payments.
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Four Types of Debt
Types of debt
1. Credit card debt
A credit card is a card issued by a financial company. Every time you swipe a credit card for a purchase, you’re borrowing money. Credit card debt is unsecured debt which means that a higher interest rate is charged.
With a credit card, you can use the money lent to you to make payments, but you agree with the financial company to pay back the original borrowed amount, along with any interest or fees. The average credit card interest rate is 18.26% for new offers and 14.54% for existing accounts.
A credit card comes with borrowing limits. The limit normally depends on your credit score.
When you pay off the balance of your credit card, you open back up your line of credit. Say that you have a credit card with a monthly $2,000 limit. You spend $1,000 in one month so you only have $1,000 left to spend. If you pay off that $1,000, your limit goes back up to $2,000.
The pros of having a credit card is building up your credit score. But the cons are that it can get costly very quickly. See, banks want you to stay in credit card debt because of the compounding interest. They make a lot of money off you!
According to the 2019 Experian Consumer Credit Review, the average American has $6,194 in credit card debt.
Don’t wait until the end of the month to pay off your credit card debt (aka don’t carry a balance). With the interest rates being so high, you’ll rack up a lot more than you borrowed as interest compounds daily. Instead, pay off your credit card every two to three days so you never pay any in interest.
2. Auto loan
Auto debt is created by taking out an auto loan to purchase a vehicle. An auto loan lender might be a bank, dealership, credit union, or an online lender.
The interest rates are normally better than credit cards because your debt is secured by the car you’re buying. But since it’s used as collateral, your vehicle can be repossessed if you stop making payments.
The pros of taking out an auto loan is that you don’t have to pay the full amount for the vehicle up front. It also helps you build up your credit (if you make your payments on time).
The main con of an auto loan is that it’s debt. You have to make monthly payments which takes away money that could be used for savings or investments. You also have to pay interest.
Let’s say you buy a car for $13,000, taking out an auto loan to cover the full amount. The interest rate is 3.6% and the loan is for six years. In addition to paying off the principal amount (aka the amount you borrowed), you’ll end up paying off almost $1500 in interest. Try to put more down on the car or pay for it completely in cash so you’ll pay less in interest.
Use a car loan as a tool to get a car that you can afford. Your car depreciates or goes down in value as soon as you drive it off the car lot. Because of this, it’s best to drive your car as long as possible.
Just like an auto loan, a home loan or mortgage helps you finance a home that you couldn’t necessarily purchase upfront. A home loan is secured by a property or real estate.
As the buyer, you promise to pay back the loan over a certain time frame for a certain amount.
But here’s the thing…you don’t completely own your home with a mortgage. The lender owns whatever you haven’t paid off. So say that you put 5% down on your house. You own that 5%. The lender owns the remaining 95% of the house. When you take out a mortgage, think of it as financing a home, rather than fully owning it.
The pros of a mortgage are that you can have a home – a space that’s yours. This is a huge emotional win! But the cons are that you’ll pay a lot in interest for a 30-year-loan.
Here’s an example: if you finance a home for $150,000 at a 5% interest rate for 30-years, you’ll end up paying almost $140K in interest! And that’s in addition to paying off the principal amount.
Your money is also tied up in payments so you can’t invest it in other things like the stock market. It also takes time and money to maintain a home. Things pop up that you don’t have to pay for when you rent (hello, busted plumbing!). Finally, if you want to move, it’s much harder. Selling is a time-consuming process.
That said, a mortgage isn’t considered bad debt, as long as you can afford the monthly payments. Your mortgage should be less than 28% of your gross monthly income.
4. Student loan
Student loans, whether federal or private, are taken out to cover college expenses. Approximately 42.9 million Americans with federal student loan debt each owe an average $37,105 for their federal loans. Some owe $100K and more!
Though common, it doesn’t make it any less easy to get out of student loan debt. Student loans are unsecured. The bank or lender can’t repossess your diploma if you don’t make payments.
But at the same time, student loans are unforgivable and can’t be declared in bankruptcy. This means that you have to pay it off to get rid of it.
Types of student loan repayment options include:
- Income-Based Repayment
If you can’t make payments now, you can defer the payment period for three years. If your loan is subsidized, your interest and payments stop. If your loan is unsubsidized, interest still grows, but you don’t have to make payments.
Or your loan might go into forbearance. You have to pay interest during this period OR the interest will be applied to your principal balance. Both forbearance and deferment might seem great in the short-term, but these options still make your debt grow!
Now, sometimes, student loan forgiveness is possible for federal loans, but any forgiveness is still taxable. You will also owe the IRS money. Paying off your student loans is still the best way to get out of a student loan debt. And the sooner you start, the better!
Create a Debt Payoff Plan for Different Types of Debt
Not all types of debt are bad. A mortgage, for example, is considered “good debt” because it can be an investment in your future. But debt, when out of control, can quickly hurt your ability to save and invest. We recommend making a plan to pay off debt as quickly as possible.
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