What is debt? Definition, types and more

Debt is a part of everyday life. And there are different types of debt and many ways people can use it to their advantage. Understanding debt can help you better plan for it and manage what you owe. Read on to learn more about what debt is and how it works.

Key takeaways

  • 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.
  • There are things to consider when taking on debt, such as how it could affect your credit and what opportunities it may open up.  
  • Some debt management strategies include the debt snowball and debt avalanche methods

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What is debt?

Debt is money owed by one party to another. For borrowers, debt has many uses. For example, it can be used to make purchases that might otherwise be out of reach. And using debt responsibly is one way to build credit over time. 

Here’s how it usually works: A borrower applies for a loan or line of credit from a lender. If the lender approves the application, the borrower has to agree 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 things like a person’s creditworthiness, including their credit scores and their debt-to-income ratio, to get a sense of their financial health.

Types of debt

Not all forms of debt are the same. And different types of debt may come with different obligations. So understanding the differences between things like secured and unsecured debt and revolving and installment debt can help you better plan out how you might use debt to achieve your financial goals

And be aware that debt can also take multiple forms: For example, an auto loan is an installment loan that’s also typically secured. 

Take a closer look at some of the main types of debt. 

Secured debt

Secured debt is a type of debt backed by collateral. When an individual takes out a secured loan or gets a secured credit card, they use collateral to secure it. Common forms of collateral include cash, real estate, vehicles, investments and insurance policies. In the case of a mortgage or auto loan, the collateral may be what the loan is being used to purchase.

Depending on the type of loan, the lender may place a lien on the asset until the debt is paid off. If the borrower fails to pay off the loan in the agreed upon time frame, the lender can foreclose on the collateral to recover the loss. 

In the case of a secured credit card, a security deposit acts as collateral. Think of it like the security deposit a renter pays before starting a lease on an apartment.

Unsecured debt

Unsecured debt is not backed by collateral. Common types of unsecured debt include student loans, some credit cards and personal loans

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 interest rates for unsecured loans are typically higher than rates for secured loans.

Revolving debt 

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

Lenders typically set up a credit limit that sets 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

Installment debt 

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 is 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. 

How do interest rates affect debt?

When it comes to borrowing, the CFPB says interest is “a fee charged by a lender, and paid by a borrower, for the use of money.” Interest and how it affects debt changes based on the type of debt.

For example, installment loan payments—for debt like mortgages and auto loans—are typically split between the original amount borrowed and interest. So if the loan is paid back early, it can reduce the total amount of interest paid over the life of the loan. 

For revolving accounts, such as credit cards, paying off the balance on time each month is a way to avoid paying interest on new purchases. 

What to consider when taking on debt

There’s plenty to consider before taking on any type of debt. But it might help to start with a few broad ideas:

  • Chances to build credit: Taking out loans and paying them back on time consistently can help to build credit. But on-time payments aren’t the only way debt can affect your credit. It’s worth learning more about how things like credit age, credit mix and credit utilization could affect credit too.
  • Flexible funding: Rather than having to spend savings, taking out a personal loan or line of credit is one way to help finance 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 a family purchase their first home, a student 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.

Debt management strategies

Managing debt can help on the path to financial stability. And knowing the ins and outs of debt repayment can help borrowers repay debt while still saving money. Here are a few common tactics to manage and repay debt.

Debt snowball method 

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. 

If you’re trying this method, keep in mind that you need to continue making minimum payments on all debts throughout the process to keep your accounts in good standing.

Debt avalanche method 

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. But like the snowball method, it’s important to continue making minimum payments every month.

Debt consolidation

Debt consolidation can be an effective way to manage existing balances. 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. 

And there are multiple ways to consolidate debt. Some of them include:

  • Balance transfer card: These credit cards allow a person to transfer their debt to a new or existing credit account. They often feature an introductory 0% APR for a specific amount of time.
  • Home equity loan: A home equity loan allows an individual to access their home equity as cash by using the home as collateral. Homeowners can then use some or all of the loan to repay existing debt.
  • Personal loan: 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 plan: A debt relief agency may negotiate with creditors on behalf of the borrower and help come up with a plan for repayment.

Debt in a nutshell

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. And if you’re still learning about debt, this debt glossary may help you get familiar with common terms and phrases related to debt.

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