What You Need to Know About Debt

What is Debt?

Debt is the obligation to pay money (or other agreed value) to another party, such as borrowing money from your brother to buy a car. The debtor is the one who owes the debt; you are the example. The one to which the debt is owed is called the Creditor, your brother in the example. Debt can generate value, increase your net worth, or be a weight upon you if misused. Knowing how to handle debt can mean being financially grounded or drowning.

The following section will discuss some of the more common types of debt. We will also show how these debts can be appropriately used to be financially grounded or misused to cause anxiety and regret.

 

Secured and Unsecured

With secured debt, an asset, such as the car in the example, is used as collateral for the debt. Thus, the debt is secured by the asset. If the debt is unpaid, the Creditor will take the asset to cover the remaining debt.

With an unsecured debt, there is no asset attached to it. This is the most common type of debt. The most common example of this would be credit card debt. No assets will cover the remaining debt if the debt is not paid. The Creditor will likely send the debt to a debt collector, who may sue you for the balance plus fines/fees.

Let's get into the details of the sub-types of debt that belong to each type.

 

SECURED DEBT SUB-TYPES

Mortgage

When you buy real estate, whether for your residence, a vacation property, or an investment, you must pay the property owner the real estate price in full. This can be done by paying cash for the real estate or taking out a mortgage from a financial institution such as a bank or a credit union. The money borrowed in the mortgage goes to the property owner for purchase, plus any fees and/or commissions owed to agents if they were involved in the transaction. You are then left with a mortgage to the financial institution that will be paid off over a set term, typically 15 or 30 years, although there are longer and shorter terms.

The mortgage can be either a fixed-rate mortgage or an adjustable-rate mortgage (ARM).

 

Fixed-Rate

In a fixed-rate mortgage, the debtor (borrower) pays the same interest rate for the life of the mortgage. This type of mortgage stabilizes the payment somewhat. Your mortgage payment (principal and interest) does not change if interest rates increase. If interest rates go down, you can refinance to take advantage of the lower rates to lower your mortgage payment.

 

Adjustable-Rate

With an adjustable-rate mortgage (ARM), the mortgage payment adjusts as interest rates increase or decrease. This type of mortgage can be appealing in the short term as it can be more affordable. If interest rates rise, you may find that you can't afford the mortgage payment at a higher rate. This type of mortgage does not offer stabilization like a fixed-rate mortgage.

 

Auto Loans

Like a mortgage, when you buy a vehicle, the seller must pay in full before you can take possession of it. If you don't have the cash to cover the agreed-on price, an auto loan will cover the amount due. Auto loans are for a set term and a set interest rate. The interest rate you can qualify for depends on your credit rating. The better your credit rating, the lower the interest rate. The lower your credit rating, the higher the interest rate. The most common term for an auto loan is 60 months (5 years), but there are options for shorter and longer-term loans.

 

Home Equity Loans

A Home Equity Loan is taken out based on the equity you have in your home. Your home's equity is the appraised value minus any outstanding debt(s) against the property. A home equity loan is considered a second mortgage on the property because it is secured by the property. You must have at least 20% equity in your home to qualify for a home equity loan.

 

UNSECURED DEBT SUB-TYPES

Credit Cards

Credit card debt is accumulated by not paying the monthly billing cycle balance. If you charge more on your credit card than you pay off each month, you will go deeper and deeper into debt. Also, when the entire balance is not paid off each month, the credit card account accumulates interest based on the unpaid balance from the previous billing cycle as a fee. The unpaid balance then grows by this fee amount. This is how the cycle begins.

You might purchase an item or service with a credit card because you can defer the payment or spread the payoff over an extended period. Some credit cards, especially retail store credit cards, have zero percent interest for a term to entice you into using the store's financing to make the purchase.

Why bother saving up for that new grill from the home improvement store when you can have it today? If you use the store's credit card, there will be no interest for 90 days. You'll pay it off in less than 90 days. Beware: If you don't pay off the full amount in the no-interest term period, you will be charged interest on the full purchase amount backdated to when the purchase was initially made. Sneaky.

Let's say you buy the grill indicated above for $900, with no interest for 90 days; after that, you will have an annual percentage rate (APR) of 18.99%. You say you can quickly pay off the grill in 3 months. That's only $300 per month, then done. You get to the end of the 90 days, only having paid $400 on the grill. No, the store credit card's interest and backdated application of interest come into play. You initially owed $900. After paying $4,00, you should have an unpaid balance of $500. Wait, with the unpaid balance triggering the backdated interest, your actual unpaid balance is $ 542.73. A large percentage of most retail stores' income is earned from interest on store credit card usage. In 2017, Macy's credit cards made up 39% of their total profit. The total profile for Macy's in 2017 was $1.9 billion.^[1] That's $741 million from store credit card interest alone.

 

Student Loans

With the cost of attending college or university continuing to rise each year, more and more students, and their parent(s), are taking out student loans to pay for some, most, or all of the cost. Over the past 30 years, the average price of attending a four-year school has nearly tripled.^[2]

Over half of the students (current and past) used student loans to pay for some portion of their education. As of 2020, the United States had $1.57 trillion in student loan debt. Unlike most other forms of debt, student loans can not be removed with bankruptcy.

Some student loans may be forgiven depending on what degree you obtain from school. Examples are teachers and doctors who serve in low-income areas. There are many student loan forgiveness programs, so investigate them. See this Forbes article for more information.

 

Medical Bills

A trip to the emergency room or an extended stay in the hospital can result in thousands or tens of thousands in medical bills. If you have medical insurance, a portion may be covered, leaving you with out-of-pocket deductibles. Medical insurance may not cover everything, and you'll be responsible for paying the remainder. You'll be responsible for the entire amount if you don't have medical insurance. 

If the bill(s) aren't paid promptly or if payment plans are not set up, these unpaid medical bills may end up in collections. Debts in collections negatively impact your credit score and usually have high interest rates and penalties attached to them.

 

Signature Loans

A bank, credit union, or financial institution grants a signature loan. No collateral is required for a signature loan. Your income and credit history determine the interest rate on a signature loan. Signature loans are typically given for amounts ranging from $500 to $50,000 over a repayment term of 5 to 10 years.

 

Lines of Credit

A line of credit is a loan created with a bank, credit union, or other financial institution that can be drawn upon as needed. The terms of the line of credit may state that the loan is to be repaid immediately or over a term. Interest on a line of credit is charged immediately upon drawing money from it.

 

Court Judgments

A court judgment comes as a result of a lawsuit. Once a judgment is rendered, a debt collector will take over the collection of the amount due using tools such as wage garnishment. The lawsuit against you started as an unpaid debt you had, which then went to collections from whichever institute you initially owed. The debt collector sued you for the unpaid balance, penalties, and fees.

 

Owed Taxes

Owed taxes or tax debt is money owed to a taxing authority past its initial due date. The taxing authority can be the Internal Revenue Service (IRS), the local appraisal district, or state taxing entities.

The penalties for tax debt are among the highest allowed. They can include wage garnishment, loss of property, and the use of other tax refunds to pay.

 

Conclusion

As you can see, there are many different types of debt. Debt can be a helpful tool, but if used unwisely, it can be an anchor around your neck, holding you back.