What is debt? Definition, types and more

Debt is often a part of life. There are different types of debt and many ways people can use it to their advantage. Understanding how debt works can help you plan your financial future and manage what you owe.

Learn more about what debt is and how it works.

What you’ll learn:

• The Consumer Financial Protection Bureau (CFPB) defines debt as money someone owes to another person or business.

• Some of the main types of debt include secured, unsecured, revolving and installment debt.

• Managing debt responsibly over time may help you build good credit. 

• Some debt management strategies include the debt snowball and debt avalanche methods.

Debt is money you borrow that you have to repay. For borrowers, debt has many uses, like making purchases that might otherwise be out of reach. And managing debt responsibly is one way to build credit over time.

Governments and companies can take on debt, but this article focuses on individual debt, also known as consumer debt.

Borrowing money isn't inherently good or bad. But debt may be considered “good” when it’s used to improve your long-term financial health, build wealth and achieve personal goals. A mortgage could be an example of good debt if it helps you achieve your objective of owning a home or increases your net worth. 

Debt may be considered “bad” if it doesn’t offer long-term benefits or comes with payments that are unmanageable. Loans with high interest rates or unfavorable repayment terms could be examples of bad debt.

Usually, a borrower applies for a loan or line of credit from a lender. If the lender approves the application, the borrower agrees to pay it back, often with interest, to receive the money or access to the line of credit. 

As part of the approval process, lenders may review a person’s creditworthiness to get a sense of how likely they are to repay their debt. This process can include analyzing their credit scores and their debt-to-income ratio to get a sense of their financial health.

Not all forms of debt are the same. There are four main types of debt that may be helpful to understand: secured vs. unsecured debt and revolving vs. installment debt. 

Here’s a closer look.

Secured debt is backed by collateral, which is an asset a borrower uses to secure the loan. Collateral can be a physical asset, like a car or a home, or a financial asset like cash, investments or insurance policies. 

In the case of a secured credit card, a security deposit acts as collateral. A mortgage is an example of secured debt in which the property itself acts as collateral. If a borrower defaults on secured debt, they could lose the collateral.

Unsecured debt isn’t backed by collateral. Common types of unsecured debt include student loans, personal loans and some credit cards. 

Without collateral to back the debt, eligibility requirements may be a little stricter for certain types of unsecured loans, like credit cards and personal loans. And in some cases, interest rates for unsecured loans may be higher than rates for secured loans.

Revolving debt, also called revolving credit or open-ended credit, lets a borrower continually borrow money and pay it back as long as their account is open and in good standing. 

Lenders typically set up a credit limit that determines how much a person can borrow at a time, as well as a minimum payment each month. Common forms of revolving debt are credit cards, charge cards and other lines of credit.

With installment debt, you borrow a specific amount of money and receive it all at the beginning of the loan. That amount is called the principal. It’s then typically paid back along with interest in set amounts, or installments, over the length of the loan. 

Common types of installment loans include mortgages and personal loans.

When it comes to borrowing, the CFPB says interest is “the cost you pay to the lender for borrowing money.” The higher the interest rate on a loan is, the more expensive it may be to borrow that money. 

Here are a few ways interest rates can impact you: 

• Spending power: If you have to spend more to borrow the same amount, you’ll have less cash on hand for other things.

• Monthly payment: When interest rates are higher, your monthly payment is larger for the same loan amount. That’s why mortgage rates, for instance, can be important.

• Increased cost of debt: If you don’t pay off your credit card balance, for example, you’ll be charged interest on what you owe. The higher your interest rate, the more you’ll be charged in interest.

Like any financial decision, taking on debt comes with potential upsides and risks. Here are a few things to consider:

• Chances to build credit: Taking out loans and consistently paying them back on time can help you build credit. This can also affect your credit by increasing the credit age of your accounts and diversifying your credit mix.

• Flexible funding: Rather than using your savings, applying for a personal loan or line of credit is one way to help cover unexpected expenses. But it helps to consider how it might affect your budget. Good debt could turn into bad debt if it becomes unmanageable.

• Opportunity: Taking on debt could help you purchase your first home, attend college and more. But it’s important to be realistic about what’s affordable. 

• Potential tax deductions: Not all debt is deductible on annual taxes, but some types of debt are. Interest on mortgage payments, student loans and other loans may be tax-deductible and could help a borrower lower their tax liability.

• Interest rates: When you borrow money, you may have to pay interest. The higher the interest rate, the more you may owe. So whenever you take on new debt, you may want to consider how the interest rate will affect your finances.

Managing debt can help on the path to financial stability. Here are a few common strategies for managing and repaying debt.

The debt snowball method starts with small payments that grow over time. Borrowers pay off the smallest of their debts first before moving on to larger ones. As they pay off each balance, they roll any extra money into payments toward larger balances, resulting in a snowball effect.

Similar to the snowball method, the debt avalanche method has borrowers pay off debts in a specific order. But rather than organizing payment by total amount, the debt avalanche method pays off loans with the highest interest rate first. This may decrease the amount of interest the borrower pays over time.

Debt consolidation is the process of combining multiple debts into one loan. Consolidating debt may help reduce monthly interest payments and make the repayment process more manageable. 

There are multiple ways to consolidate debt, including:

• Balance transfer credit cards: These cards allow a person to transfer their debt to a new credit account. They may feature an introductory 0% APR for a specific amount of time.

• Home equity loans: A home equity loan lets an individual access their equity by using their home as collateral. Homeowners can then use some or all of the loan to repay other existing debt.

• Personal loans: A personal loan may offer a fixed interest rate that remains constant for the life of the loan. Like a home equity loan, borrowers can use the funds from a personal loan to repay their debts and combine multiple balances into a single payment.

• Debt management plans: A debt relief agency may negotiate with creditors on behalf of the borrower and help develop a repayment plan.

Debt can affect many different aspects of life. And knowing how to manage and use debt can help you get a head start on your financial goals. 

If you’re trying to get out of debt, this guide to paying off credit card debt could help.