The 7 Different Types of Debt

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 take a student loan to pay college tuition, and most homeowners take on mortgage debt. Debt acts as an essential driver of the modern financial ecosystem. 

The best approach to dealing with debt is to stay prepared and be aware of the different types of debt and their implications. 

What Is Considered Debt?

Simply put, debt is anything (usually money) that one party owes 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, specifically 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 that receives the money and owes the debt is called ‘the debtor.’ The terms and conditions for debt repayment are pre-decided and sealed with a legal contract. 

The creditors use debt as an investment opportunity and usually charge interest on it. Similarly, the debtors use debt to fulfill their immediate financial necessities and repay the principal amount with interest. 

Unsecured vs. Secured Debt

Depending on the risk involved for the creditor and terms of allotment, all debt can be classified into two broad types: unsecured and secured. It’s important to understand what the term “collateral” means to 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 you fail to repay the debt, the creditor can use (sell or acquire) the collateral to recover the amount you owe. 

Unsecured Debt

Unsecured debt is a type of debt that is not protected by collateral. This means that you don’t have to lien any existing assets to the lender to guarantee debt repayment. Here are a few things to know about unsecured debts:

• Unsecured debts have high interest rates due to the absence of collateral
• These are risky for creditors 
• Some common examples are credit cards, personal loans, and student loans.

Secured Debt

These debts are protected by collateral. A typical example of secured debt is a car loan. The lender provides you with a lump-sum amount to purchase the car but places a claim of ownership on the vehicle if you fail to repay the loan within the agreed period.

Here are the key things to know about this type of debt: 

• Secured debts have lower interest rates due to collateral
• They’re relatively safe investments for creditors
• Common examples include car loans, mortgages, and gold loans

Revolving vs. Installment Debt

Another classification of debt is based on the repayment schedule. The money you borrow can be repaid in equal regular installments or continually used with partial payments. 

Revolving Debt

The best example of revolving debt is your credit card. This type of debt is open-ended and comes with a credit limit. You can use a portion of it or up to the total credit limit and pay it before the billing cycle ends (usually a month). The credit limit is then replenished. 

There’s also an option to pay a portion of the outstanding amount (used credit limit), usually called the minimum payment. However, paying only the minimum each month means you’ll pay high interest rates on the outstanding balance, which can add up over time. 

The most common examples of revolving debt are credit cards and lines of credit. The best use of these kinds of debt is paying the outstanding balance in full every month. 

Installment Debt

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 variable rate of interest, which can vary based on different factors. 

Each installment includes a portion of the principal and interest charge. 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. 

1. Credit Card Debt

Over 75% of households in the U.S. have at least one credit card. It’s also one of the top payment methods for making purchases. 

Credit card debt is a revolving and unsecured debt. Whether you can get a credit card and the limit you qualify for will depend on your credit score and other factors. 

Interest rates for credit card debts are usually high because they are unsecured. With the current average credit card rate at 27.91%, it’s important to charge what you can afford to repay on your card and clear your balance in full each billing cycle.

2. Mortgage Debt

The leading source of debt for Americans is mortgage debt. Mortgages are secured and installment debts with a typical repayment period of 15 to 30 years. The interest rate can be fixed or variable. The interest paid on the mortgage is usually tax-deductible.

3. Personal Loans

Personal loans are unsecured installment loans that can be used for any purpose. You should have a good credit score, a reliable source of income, and a low debt-to-income ratio to be eligible for a personal loan. 

These loans typically have a duration of 12 to 60 months, and the best personal loan interest rates are currently 7.49% to 29.99%. Interest paid on a personal loan is not tax-deductible. 

4. Student Loans

Student loans make up a big portion of debt for Americans. Most students take federal student loans to pay for their college tuition. These are unsecured loans with interest rates ranging between 5.50% to 8.05%. 

These loans usually have a repayment term of 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. 

5. Auto Loans

Auto loans are secured installment loans where the lender treats the vehicle as collateral. These loans usually have a term of three to six years, with an average interest rate of 7.03% for new cars and 11.35% for used cars.

The creditor is legally allowed to seize the vehicle if you fail to repay the loan. Payments made for auto loans are not tax-deductible. 

6. Medical Debt

Medical debts are unsecured, and they’re incurred when you can’t pay your medical bills in full. For example, if you get treated at a hospital and can’t clear your bill, you may be able to work out a repayment plan with the hospital’s billing department and negotiate a lower service price. 

The IRS allows you to deduct qualified unreimbursed medical expenses exceeding 7.5% of your adjusted gross income. A good health insurance plan is always the best option to avoid medical debt. However, your insurance plan may not cover certain expenses.

7. Tax Debt

A tax debt occurs when you fail to pay your taxes or if there are inaccuracies on your tax returns. You’ll owe the debt to the IRS. The interest on outstanding tax compounds daily is usually the federal short-term rate plus 3 percent. 

Overlooking tax debt for an extended period can result in a significant amount of interest and penalties. 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, and have a plan to repay before you borrow. 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. Pay credit card debts in full at the end of each month. Use debt repayment strategies like debt snowball or avalanche. 
• Maintain a good credit score and credit history. It plays a vital role in determining the interest rates you’ll qualify for. 
• Consolidate multiple debts into one, especially if you find cheaper interest charges.

Compare Different Types of Debts Before You Borrow

With so many different types of debts available, it’s important to understand how they work and the risks involved. The type of debt you should borrow will depend on what you want to use the money for.

Regardless of the type of loan you borrow, it’s important to compare interest rates offered by different lenders and have a plan on how you’ll repay it.