Understanding the types of debt

The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.

“Debt” is the word that keeps a lot of Americans up at night. In fact, one 2019 survey found that 25 percent of Americans report worrying about their financial situation all the time. While debt can feel overwhelming and shameful, it’s essential to understand that not all debt is created equal.

Debt is a financial obligation that requires an individual (the debtor) to pay money back to another party (the creditor). It’s a way for us to receive an item or service now but pay for it later. While the term “debt” often has a negative connotation, there are different types of debts, and not all are necessarily bad. This article will discuss the different types of debts, including what is considered a “good” debt and what is considered a “bad” debt.

Is it always bad to have debt?

No, it’s not always bad to have debt. Debts are typically split into two categories: good debt and bad debt. Good debt is more like a necessary evil, though—you might just think of it as “better” debt.

Good debt

Simply put, good debts are investments either in yourself, your business or your future. Good debts are ones that will increase your net worth or have future value. Examples of good debt that will increase your net worth over time are mortgages (a home) or student loans.

As you pay off your mortgage, you’re building equity. This equity is considered an asset and increases your net worth. A student loan also increases your net worth as it gives you the skills you need to grow your career and income.

An example of a good debt that helps you generate income is a smart investment or a small business loan. You may not see the returns right away, but these debts have the potential to earn returns in the future.

Lastly, it might surprise some individuals to learn that consolidated debt is considered good debt. Consolidated debt is when you take out one large personal loan to pay off several smaller loans with varying interest rates and timelines. This type of debt is a smart decision that usually means you’re paying less interest overall on all your previous outstanding debts.

Bad debt

Bad debt usually has one of three characteristics:

• it cannot be reliably repaid and will incur interest,
• it purchases a depreciating asset, or
• it cannot generate income in the long term.

Unfortunately, bad debts typically carry high interest rates. Credit cards are an example of bad debt. The average credit card interest rate is 16 to 20 percent.

Payday loans are even worse. Approximately 12 million Americans take out payday loans annually. And, on average, the people taking out these payday loans only make $30,000 each year. The average interest rate on payday loans varies by state depending on the specific state’s regulations. In Nevada, the average APR is 652 percent, while in Virginia, it’s 254 percent.

Using that Virginia rate, let’s examine a $500 loan over a 12-month period. The borrower will end up with a monthly payment of $117.57, pay $910.84 in interest and pay a total of $1,410.84 to borrow $500. That $910.84 in interest could’ve been put toward better financial decisions such as saving, investing or paying off existing debt.

Lastly, auto loans are bad debts because cars are a depreciating asset. We’ve all heard the expression that cars start losing value the minute you drive them off the lot. In fact, a brand-new vehicle can drop by more than 20 percent after 12 months of ownership.

One way to identify bad debt is to recognize that it costs you more money than the initial price tag.

What are the main categories of debt?

When you’re trying to determine whether a debt is good or bad, it can help to understand these three main categories used to define debt: secured, unsecured and revolving.

Secured

A secured debt requires some form of collateral. Car loans and mortgages are common examples of secured loans. The auto dealership gives you a car after approving you for a loan. Or, the bank approves you for a mortgage on a property. A credit check is needed on secured debt to ensure the borrower is reliable on payments. If the borrower stops making payments, the creditor can take back its property.

Unsecured

An unsecured loan doesn’t have any collateral; the creditor is just trusting that the borrower will pay back the debt. As these types of loans are riskier for the lender, they often come with higher interest rates.

The borrower is bound to pay back the debt by a contractual agreement. The creditor can take them to court for failure to pay back the full amount, including interest. Some common examples of unsecured loans are credit cards, medical bills and gym memberships. Often when a lender can’t get their payments, they contract out the negative balance to a collection agency to retrieve payment.

Revolving

Revolving debt is a defined contractual agreement that allows an individual to borrow up to a maximum amount on a revolving basis. As long as the account is open, the individual can borrow the money at any time. Some examples of this are credit lines or credit cards.

Revolving debt can have a fixed interest rate (credit cards) or a variable interest rate (a credit line). Additionally, this type of debt can come secured (a home equity line of credit) or unsecured (a credit card).

Often, if you have a good credit history, you’re given access to higher amounts of revolving debt—for example, increases to your credit card limit.

How to manage your debt

Your debt is a crucial factor in determining your credit score. It’s incredibly important to manage debt properly, no matter what kind of debt it is.

Choose your debts carefully

Whenever possible, don’t take out debt you don’t need. If you can live without the purchase, it’s often better to buy it when you can pay it off right away.

Additionally, always watch out for interest rates and other terms. A credit line likely has a lower interest rate than a credit card, and a credit card has a lower interest rate than a payday loan. Examine all your options and prioritize the loan with the lowest interest rate. As a general rule of thumb, always try to avoid payday loans.

Always pay off revolving debt

It’s very easy to lose control of things with revolving debt. At the very least, you want to make your minimum payments on time. However, try not to make this a habit. Preferably, you want to pay off your revolving debt in full every month. If you can’t do so, it means you’re spending beyond your means and you need to cut back.

Look out for your credit

The different types of debt you carry and how you handle them can have long-standing consequences. Many types of debts are attached to your credit report and credit score. Your credit score impacts many areas of your life. A poor credit score can stop you from getting a phone, a car, a rental agreement, a property and sometimes even a job.

Always monitor your credit score and try to keep it above 670. If your credit score dips below this amount, get a copy of your credit report and consider credit repair services.

At Lexington Law, we understand how challenging it can be to overcome debt and a less-than-ideal credit score. If you have inaccurate and unverified negative items weighing your score down, get credit help from our team. Start taking control of your credit and finances today.

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